In order to understand this development, one must first consider the $7 trillion-a-day repurchase market. Repurchase (repo) agreements are transactions in which a borrower "sells" securities to a lender, with an agreement to purchase those securities back at a later date for a specified price. In effect, the borrower is taking out a secured loan, with the security acting as collateral. The difference between the borrowers "selling" price (the amount of money loaned) and the price at which the security is repurchased represents the interest on the transaction.
Repo agreements play an important role in allocating short-term capital within financial markets. Securities dealers use these instruments to finance their market-making and risk-management activities, like speculative investments or covering short positions. Some investors will use spreads between certain "special" collateral (usually US Treasuries) and general lending rates set by the Federal Reserve. Imagine a securities dealer who "sells" her treasury with an agreement to repurchase the collateral on 2% interest and then uses the cash received to finance an investment that earns 3%. The dealer has successfully manipulated a 100 basis point spread to her advantage.
One would expect a natural floor for repo rates. That is to say, it seems logical that these quasi-interest rates would always remain positive. Borrowers would agree to pay a higher price for the collateral in the future, in exchange for cash on hand. However, the current economic collapse has created serious distortions in the market. Treasuries are in such high demand at the moment that lenders may soon pay a premium to gain the security. Since the bankruptcy of Lehman Brothers in September, investors have been almost giving away cash to get Treasuries. Repo rates have fallen to 0.05 percent for a 5-year note maturing in October 2013, and general treasury yields are tumbling.
There is still much disagreement about how negative repo rates would actually affect the economy. During Japan's "Lost Decade" of the 1990s negative repo rates developed as a result of the country's zero-interest rate. In 2003, repo rates dipped negative in the US as traders tried to cover their short positions on the 10-year note.
In the contemporary climate, the Treasury may impose negative repo rates as a way to stop "fails" on repurchase agreements. As the lending markets gum up, trillions of dollars in securities are not being delivered or received as per the terms of repo agreements. There is, at present, no penalty for failing to deliver the collateral in such a deal. As these fails exacerbate the liquidity crisis, officials are considering policies that would lead to negative repo rates. Under such conditions, holders of US Treasuries would be paid a premium to borrow money from investors through the repo market.
The result would likely increase demand for short-term treasuries (driving down already low yields) and potentially more problems in the bond market. Stocks are heading for a huge two-day rally, but the gains should be short-lived. Following the gloomy economic data this past week, the risk premium on the 10-year US Treasury CDS blew out to record levels. Along with many observers, it seems several foreign central banks are beginning to doubt the efficacy of America's bailout plans.
Monday, President-elect Barack Obama held a press conference that provided a modest intraday rally for the markets. Now with his team in place, the next administration will have to craft policies that address dizzying (and at times unthinkable) economic realities.
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6 comments:
Hello, Ed
I read the New York Fed research paper you drew on in the context of another discussion. In 2003, like today, there was what amounted to a short squeeze on treasuries. Then, with yields rising, so many market participants wanted to borrow the on-the-run treasury to short, that they became more valuable than the cash available in the repurchase market. Ordinarily the demand driver was for cash, but it switched in this instance from the banks to speculators, for securities.
But an interesting thing happened. Because of the option to "fail" without penalty, you could borrow the note, sell it on the market with no intention of delivering it back within the time frame of the repurchase agreement. Because you could just roll over your collateral at 0%, arbitrageurs could effectively short the treasury in the most liquid market in the world, while financing it at 0% (usually you would pay a spread of several hundred basic points to your dealer). If demand ticked down for treasuries you could cover whenever you wanted for a few cents on the dollar.
Naturally, this squeezed the lenders of treasuries, who essentially incurred a cost of carry on the cash that exceeded the collateral rate, so they offered negative repo rates to stop the fails, be out of cash and back in treasuries. The natural way to stop this would be to impose some penalties on failures to deliver, but this would impose heavy legal fees and a more cumbersome regulatory structure than the Fed currently could operate. The terms of repurchase agreements would have to be changed to be guaranteed.
Then the market for treasuries was weak, there wasn't widespread illiquidity. It also binds the Fed's hands, doesn't it, having both a FOMC funds target and having to auction securities to prevent liquidity sudden stops?
What's going on now appears different than 2003, at least to me. The demand for Treasuries is less because of a internal dynamic than a generalized low risk appetite. Perhaps European banks are having to buy dollar-denominated securities to cover their implied dollar shorts (that allowed them to get around Eurozone capital requirements) as well. If on the run yields fall to zero it will likely be because of fear of holding cash (many money market instruments have been set up after the Fed's Sep 15th-or-so guarantee and the commercial paper market is still tight). I don't see that happening.
On the other hand, banks' liquidity demands ought to balance the drive for treasuries on the repo market, even if low premia are attractive to investors in this market. I can't see the repo specials rate curve w/o a Bloomberg but I would think it would be steadier than in 2003.
The prospect of a liquidity trap is real for the monetary authorities. They have achieved some success with coordinated action -- after all the BOE still has 350 bps to go to catch up with us! But given all the tools they have used, whether liquidity injections, extending the TAF to nonbanks, swap lines, paying interest on Funds reserves, where will we turn if liquidity continues to run dry? The problem, as El-Erian and others have stated, is that monetary policy is insufficient to counter the tremendous "endogenous liquidity" in the market, and it is very hard to track those capital flows. So many pension funds, endowment funds, and SWFs are in the market that their behavior is at least an equal counterweight to the Feds. And with "shadow banks" from GE Financial to 40 billion of Citi's off-balance sheet SIVS needing liquidity for their credit securities, Fed Funds $$$ only address part of the problem.
here are some articles on repos.
still trying to figure out all the messy details, but sounds like it is the treasury equivalent of "naked" shorting in some ways.Of course, that shouldn't be driving yields lower except for the squeezing effects maybe?, so I am not sure if that is correct...hmm, I read josh's interpretation, which is interesting. anyways, here goes
http://www.aleablog.com/repos-fails/
http://declineandfallofwesterncivilization.blogspot.com/2008/10/25tn-in-repo-fails.html
http://www.euromoney.com/Article/2054070/The-US-treasury-market-reaches-breaking-point.html?LS=EMS224393
happy thanksgiving
Ed, as the sovereign debt student, help me figure this one out. Look at the US sovereign CDS 5-10 years out -- they're trading close to the level of corporates! First of all, this is ridiculous. The Fed can print as much of the world's currency as it wants, and the IRS owns 40% of every wealthy individual and 35% of every corporation in the richest country in the world.
Secondly, how can this reconcile with the treasuries' yields on this part of the curve? I know it's steep but come on. There are clearly structural liquidity dynamics driving the government debt market that derivatives punters just don't buy. How can this be possible? Either everyone is suddenly hedging risk-free assets, or there is such a need to access liquidity that few are paying attention to credit risk?
here is why the dollar is dropping -
http://www.newsneconomics.com/2008/11/its-official-fed-is-monetizing.html
the Fed buying GSE debt is an attempt to bring down final mortgage costs at the level of individual borrowers. This is equivalent to monetizing the agencies' debt, which would ordinarily be accomplished by buying treasuries thru the repo market or open market operations. It is putting money in the system that wasn't there before. People have talked about the inflationary impact of gov't spending and the Fed liquidity programs, but until now, all that money has been "sterilized" by selling treasuries (or the Treasury doing it and depositing receipts at the Fed). Now the printing press is getting fired up.
Ed, I'm worried about main street not wall street! That's why I voted obama and cause he is going to pay my gas and morgage
Hi Ed this is an excellent post and some really interesting thoughts! Keep up the great content :-)
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