In the relative calm that is the market for U.S. Treasuries, a sense of unease over a vital cog in the financial system’s plumbing is beginning to rise.
The Federal Reserve’s bond purchases combined with demand from banks to meet tightened regulatory requirements is making it harder for traders to easily borrow and lend certain desired securities in the $1.6 trillion-a-day market for repurchase agreements. That’s causing such trades to go uncompleted at some of the highest rates since the financial crisis.
Disruptions in so-called repos, which Wall Street’s biggest banks rely on for their day-to-day financing needs, are another unintended consequence of extraordinary central-bank policies that pulled the economy out of the worst financial crisis since the Great Depression. They also belie the stability projected by bond yields at about record lows.
“You have a little bit of a perfect storm here,” said Stanley Sun, a New York-based interest-rate strategist at Nomura Holdings Inc., one of the 22 primary dealers that bid at Treasury auctions, in a telephone interview June 30.
Smoothly functioning repo trading is vital to the health of markets. The fall of Bear Stearns Cos., which was taken over by JPMorgan Chase & Co. in 2008 after an emergency bailout orchestrated by the Fed, and the collapse of Lehman Brothers Holdings Inc., whose bankruptcy in September of that year plunged markets into a crisis, were hastened after they lost access to such financing.
In a typical repo, a dealer needing short-term cash often borrows money from another dealer, a hedge fund or a money-market fund, putting up Treasuries as collateral. The cash lender can then use the securities to complete other trades, such as to close out short positions where it needs to deliver bonds.
Negative rates happen when certain Treasuries are in such high demand or short supply that lenders of cash are actually paying collateral providers interest so they can obtain the needed securities. Traders said that is a big reason why repo rates on desired Treasuries have recently gotten as low as negative 3%.
Now, more repo trades are going uncompleted, or failing, because it’s either too difficult or expensive for the borrower to obtain and deliver Treasuries. Such failures to deliver Treasuries have averaged $65.6 billion a week this year, reaching as much as $197.6 billion in the week ended June 18, Fed data show.
Uncompleted trades averaged $51.6 billion in 2013, and $28.8 billion in 2012, according to the Fed. In those cases, the borrower pays a 3% penalty.
“The effect of all the collateral issues we see now is an indication of not so much how things are, but how bad things will be when you really need liquidity,” said Jeffrey Snider, chief investment strategist at West Palm Beach, Florida-based Alhambra Investment Partners LLC, in a telephone interview June 30. “That’s when you get into potentially dire situations.”
The conditions for repo stress were on display last month. The 2.5% note due in May 2024 reached negative 3 percentage points in repo in the days preceding a June 11 Treasury auction of $21 billion in notes to finance government operations.