EXPLAINER-U.S. Treasury sell-off spills over to repo market
By Gertrude Chavez-Dreyfuss
NEW YORK, March 8 (Reuters) - The nearly $3 trillion U.S. repurchase or repo market, an opaque but vital component of the financial system, was thrown into flux last week after the cost of borrowing the benchmark 10-year Treasury note went deeply negative on Thursday, hitting a rate of -4.25%, the lowest since mid-March last year.
WHAT DO NEGATIVE REPO RATES MEAN?
The negative repo rate means some market participants were willing to pay interest on money lent to borrow the U.S. 10-year note. In general, it's usually the borrower of cash who pays interest for the loan. On Monday, the average repo rate on the 10-year was -2.91%, according to dealers.
Analysts said the negative repo rate reflects uncertainty on how long the Federal Reserve can keep its easy monetary policy.
DO NEGATIVE REPO RATES HAPPEN OFTEN?
Negative rates happen when there's high demand for a security that prompts lenders or repo buyers to offer cheap cash. Since 2018, the 10-year note overnight rate traded at -3.0% and below three times: -4.25% last Thursday, -3.50% in June 2020, and -5.75% in mid-March last year, said Scott Skyrm, executive vice president in fixed income and repo at Curvature Securities.
WHAT HAPPENED LAST WEEK?
The cost of borrowing U.S. 10-year notes went negative last week in the repo market following a surge in short positioning on U.S. 10-year notes as expectations have grown for a faster-than-expected U.S. recovery. The market has also become concerned that the Federal Reserve would raise interest rates earlier than expected.
To short the 10-year notes, investors need to borrow them from entities, such as money market funds, in the repo market, sell them, and buy them back later.
"I think what is notable about this whole thing is how long it has been since there has been heavy volatility in the fixed income market as there is today," said Glenn Havlicek, chief executive officer and co-founder of broker-dealer GLMX.
WHAT IS A REPURCHASE AGREEMENT?
In a repo trade, a borrower offers U.S. Treasuries and other high-quality securities as collateral to raise cash, often overnight, to finance their trading and lending activities. The next day, they repay their loans plus what is typically a nominal rate of interest and get their bonds back. In other words, they repurchase, or repo, the bonds.
The difference between the securities' initial price and their repurchase price is the interest paid on the loan, known as the repo rate.
Lenders typically include money market funds, insurance companies, corporations, municipalities, central banks and commercial banks that have excess cash to invest. On the other hand, dealers and depository institutions borrow cash against long positions in securities to finance their inventory and balance sheet position.
WHY IS THE REPO MARKET IMPORTANT?
The repo market underpins much of the U.S. financial system, helping to ensure banks have the liquidity to meet their daily operational needs and maintain sufficient reserves.
It allows financial institutions that own lots of securities such as banks, broker-dealers, and hedge funds to borrow cheaply and allows parties with lots of spare cash such as money market mutual funds to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities, serve as collateral.
WHAT IS THE GENERAL COLLATERAL RATE?
In general, the repo market has two types of rates — the general collateral (GC) rate and the "special" rate.
The GC repo rate corresponds to that rate of a basket of securities that are trading normally or have nothing special going on. GC securities can therefore be substituted for one another without really changing the repo rate. In other words, the buyer in a GC repo is not really concerned about the type of securities he will receive.
The fact that GC securities can be substituted for one another suggests that what drives the GC repo rate is not the supply and demand of particular issues of securities, but cash requirements. For this reason, GC repo is sometimes called cash-driven repo. As a measure of the cost of borrowing cash, the GC repo rate is tightly-linked with unsecured money market interest rates, analysts said. The interest rate charged on GC repo deals typically stays close to the Fed's benchmark overnight rate, currently set in a range of between 0%-0.25%.
WHAT IS THE SPECIAL RATE?
A special is an issue of securities that has overwhelming demand in the repo and cash markets, in this case the 10-year note, compared with similar issues. Competition to buy or borrow a special security prompts potential buyers to offer cheap cash in exchange.
A special is therefore identified by a repo rate that is distinctly lower than the GC repo rate. The demand for some specials can become so strong that the repo rate on that particular issue falls to zero or even goes negative in an otherwise positive interest rate environment. (Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Nick Zieminski)
