The rate for borrowing 10-year Treasuries in the repo market plunged to minus 4% this week, which is very rare. That means investors are essentially paying to borrow 10-year bonds, when it is normally the other way around.
Crowded short bets
But these bets are creating intense demand in the repo market for 10-year Treasuries that may be short.
“This turmoil is being caused by the oscillation of the bond market as people readjust their views on the economy,” said Scott Skyrm, executive vice president of fixed income and repo at Curvature Securities.
The 10-year Treasury rate soared to 1.6% last week, well above last March’s low of around 0.3%.
‘Cat and mouse game’
Wall Street is essentially testing the Fed, pushing to see how high the central bank will allow to raise rates before intervening.
“It’s a cat and mouse game,” said Mark Cabana, Bank of America’s head of rate strategy. “The market is challenging the Fed. The Fed is being a little shy and basically telling the market, ‘Go fix it.’
But the Fed doesn’t want to hurt the recovery or scare Wall Street.
If rates rise sharply, it would increase the cost of everything from mortgages and auto loans to junk bonds.
“It will reach a tipping point where it will have negative consequences on the financial market,” Cabana said.
The overheating debate
However, the higher rates would also indicate that the US economy is finally returning to normal after more than a decade of slow growth and anemic inflation.
Dudley said that Treasury rates of 1.6% are “nothing” and that expected returns will eventually rise to between 3% and 4%, or even more.
“The bond market right now is a bit unrealistic about their expectations for the Fed. They certainly want the Fed to stop this,” said Dudley, who was previously a senior economist at Goldman Sachs. “And I think the Fed’s view is no. We’re not going to stop this. This is normal. This is what happens when the economy looks like it’s going to recover.”
Cabana said that Dudley, whom he respects for his time working together at the New York Federal Reserve, may be taking an overly academic approach.
“The biggest risk to everything the Fed is trying to accomplish in terms of stimulating growth and achieving full employment is too high US interest rates,” Cabana said. “That would overturn the apple cart.”
The Fed’s Hotel California Problem
The Fed would probably like to take a hands-off approach this time around, as it seeks to slowly pull out of crisis mode.
However, Cabana does not believe that will happen, in part due to huge federal budget deficits created by the pandemic and efforts to revive the economy.
“The Fed will have to increase its presence in the markets. This is how this ends,” Cabana said.
All of this underscores how difficult it is for the Fed to undo its emergency policies.
“It’s the Fed’s Hotel California problem,” Cabana said. “You can leave, but you can never leave.”