Here we go again: unrest scares the repo market

Here we go again: unrest scares the repo market

by
Normally this trade happens in the background, with little fanfare. But every now and then the system breaks down, like late 2019 and again a year ago. This is another one of those moments.

The rate of borrowing 10-year treasury in the repo market dropped to minus 4% this week, a very rare occurrence. This means that investors are essentially paying to borrow 10-year bonds, usually the other way around.

Overcrowded short bets

With Wall Street economists sharply raising their GDP estimates, investors have begun making massive bets that treasury rates will rise sharply. One way to express this view is to use short treasury. (If treasury prices fall, interest rates go up.) To execute the trade, hedge funds borrow treasury in the repo market, sell it and agree to buy it back, ideally at a lower price so they can make up the difference paid in.
EXCLUSIVE: Wall Street is engaged in a rude awakening, says former Fed President

But these bets create an intense demand in the repo market after ten years of treasuries that could be shortened.

“This turmoil is caused by the bond market turning around as people rearrange their views on the economy,” said Scott Skyrm, executive vice president of fixed income and repo at Curvature Securities.

The ten-year treasury rate rose to 1.6% last week, well above the low March of around 0.3%.

Cat-and-mouse game

Wall Street is essentially testing the Fed and trying to see how high the central bank will raise interest rates before stepping in.

“It’s a cat-and-mouse game,” said Mark Cabana, head of Bank of America’s tariff strategy. “The market is challenging the Fed. The Fed is a little smart and basically says to the market, ‘Go sort it out.’

Wall Street's new bowman: the bond market

But the Fed does not want to damage the repair or harm Wall Street.

If rates rise sharply, it will increase the cost of everything from mortgage loans and car loans to junk bonds.

And U.S. stocks tumbled last week as treasury prices rose. The same thing happened Thursday, with investors alarmed that 10-year treasury yields had climbed much higher than 1.5% on comments from Fed chief Jerome Powell. Higher returns on ultra-safe government bonds will steal thunder from riskier assets such as equities.

“It will reach a turning point where it has negative consequences for the financial market,” Cabana said.

The overheated debate

Yet higher rates will also indicate that the U.S. economy is finally returning to normal after more than a decade of slow growth and anemia.

“They want the economy to overheat,” former Fed President Bill Dudley told CNN Business earlier this week.

Dudley said 1.6% of treasury rates are ‘nothing’ and the projected returns will eventually climb between 3% and 4% – or even higher.

“The bond market is currently a little unrealistic about their expectations for the Fed. They definitely want the Fed to stop it,” said Dudley, a former top economist at Goldman Sachs. “And I think the Fed’s opinion is no. We are not going to stop it. This is normal. This is what happens when the economy looks like it is really going to recover.”

Cabana said Dudley, whom he respects from the time they worked with the NY Fed, may be approaching too much academically.

“The biggest risk to anything the Fed is trying to achieve in terms of stimulating growth and achieving full employment is too high US interest rates,” Cabana said. “It will tip the apple cart.”

The Fed’s Problem in California

When the repo market blew up in the fall of 2019, the NY Fed came to the rescue by promising to inject billions of dollars into the markets. The so-called overnight repo operations have successfully calmed markets until it erupted again during the shock of the pandemic last year.

The Fed probably wants to take a practical approach this time because it wants to slowly withdraw from crisis mode.

However, Cabana does not think this will happen, in part because of the enormous federal budget deficits that the pandemic is creating and the efforts to revive the economy.

To finance the deficit, Washington must continue issuing treasury – and the Fed was the biggest buyer of these bonds. The Fed buys about $ 80 billion worth of treasury each month through its quantitative easing program (QE).
Two of the most powerful economic voices in America disagree on taxes for the uber-rich

“The Fed will have to increase its footprint in markets. That’s how it ends,” Cabana said.

One possibility is that the Fed could further increase its already massive QE program. Another option is to revive Operation Twist, a post-2008 crisis tool designed to suppress long-term rates.

All of this underscores how difficult it is for the Fed to end its emergency policy.

“This is the Fed’s Hotel California problem,” Cabana said. “You can check out, but you can never leave.”

.Source