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Thursday, March 28, 2024

As Repo Volumes Plunge And The GC-IOER Carry Trade Dries Up, One Third Of Treasury Repo Volume Is Now At Negative Rates

Courtesy of Tyler Durden

Zero Hedge was the first to observe the curious phenomenon of the collapse in the General Collateral-IOER carry trade following the implementation of the FDIC assessment rate back in early April (discussed in depth here) which continues to force repo rates far below where they would ordinarily be (and is generating an undue amount of stress on short end rates, impacting money markets, repo, and other shadow economy components, and also substantially complicating an unwind by the Fed if and when one occurs). But that’s not all. As Barclays’ Joseph Abate points out, another consequence, which is rapidly becoming appreciate by repo market players, is that up to a third of all Treasury repo volume now trades at sub zero rates, making life for money markets a living hell, which perhaps that was the goal all along… And while the fails rates for the time being has not picked up substantially (liquidity is still ample although if the Fed continues to pummel the market with its foolhardy sale of Maiden Lane II securities this may change, more on this later), it does present a complication for the Fed, should Bernanke decided to halt securities reinvestment. Granted it appears this will not be a major worry at a time when some believe QE3 is a given, and others believe QE2 Lite will be precisely the ineffectual, yet critical reinvestment of maturity securities.

From Barclays, summarizing the repo market dynamics:

In what has now become a recurring theme – and one that should stick around through July – the scarcity of bill supply and the drop-off in dealer Treasury and MBS repo activity since the FDIC assessment base change took effect are expected to keep collateral rates pinned near 5bp. Dealer repo volumes in both Treasuries and MBS are just 75% of their Q1 levels. And despite low repo rates and an attractive spread to IOER, volumes traded have not returned. Instead, it seems the decline in activity is a permanent shift in the market dynamic as banks are unwilling to expand their balance sheets to take advantage of the wider IOER-GC spread.

The combination of shrinking bill supply and the reduction in repo activity has been especially tough on money funds. Government-only money funds have few alternatives, given their mandates and the fact that, on average, they hold nearly 70% of their assets in either repo or short duration Treasuries. Prime funds, which have a bit more flexibility in their mandates, have sharply reduced their repo holdings since the FDIC assessment base change took effect. Repo allocations have declined from 15% in March to 11% currently. Prime funds have instead shifted more of their allocations to commercial paper and bank deposits, although they continue to keep a tight rein on their WAMs and already thick 7-day liquidity buffers.

Negative Rates:

With repo rates in the low single digits, the number of issues trading at less than zero has increased sharply. Roughly one-third of the Treasury repo volume now trades at rates below repo – compared to just 7% in the first quarter. Interestingly, this sharp  increase has not caused a surge in fails or incomplete deliveries. Instead, fails as a share of daily Treasury transactions remain well below 1%. We believe the 300bp penalty has kept deliveries flowing by enabling specials to clear at sub-zero rates.

Implications for Fed policy:

This has important implications for the Federal Reserve’s exit strategy. If the Fed decides to end all securities reinvestment, its portfolio will become increasingly stale as the replenishment of OTRs will cease. The staleness of its portfolio, or more specifically, the absence of new OTR holdings, will reduce the effectiveness of the Fed’s securities lending program, since it is typically the OTRs that trade most special in the repo market. We believe this will increase the premium to general collateral at which these issues trade and make it harder to cover shorts. To the extent that the fails penalty keeps activity moving in the repo market and in the most liquid OTRs, there might be less of a need for the Fed to reinvest a portion of its maturing holdings. Still, we continue to look for the Fed to reinvest at least a small portion of its maturing holdings – say 15% – to keep its securities lending program viable and support broader market liquidity.

 

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