Here we go again: turmoil shakes the repo market

Typically, these exchanges occur in the background, with little fanfare. But every now and then the system crashes, as it happened in late 2019 and again a year ago. This is another one of those moments.

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

With Wall Street economists dramatically raising their GDP estimates, investors have begun to bet en masse that Treasury rates will rise sharply. One way to express that point of view is to sell Treasuries. (When Treasury prices go down, their rates go up.) To carry out this operation, hedge funds take Treasury loans in the repo market, sell them and agree to buy them again, ideally at a lower price in order to pocket the difference.
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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.’

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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.

And US stocks fell last week when Treasury rates soared. The same thing happened on Thursday, and investors were spooked that the 10-year Treasury yield would rise well above 1.5% based on comments from Fed Chief Jerome Powell. Higher yields on ultra-safe government bonds would steal the thunder from riskier assets like stocks.

“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.

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

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

When the repo market exploded in the fall of 2019, the New York Federal Reserve came to the rescue, promising to pump billions of dollars into the markets. Overnight so-called buybacks successfully calmed markets, until they erupted again during the onslaught of the pandemic last spring.

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.

To finance the deficit, Washington needs to keep issuing Treasuries, and the Fed has been the biggest buyer of these bonds. The Fed is buying about $ 80 billion in Treasuries each month through its quantitative easing (QE) program.
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“The Fed will have to increase its presence in the markets. This is how this ends,” Cabana said.

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

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.”


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