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Wednesday, December 17, 2008

Super Low Treasury Rates Reducing Repos and With Them, Liquidity

We have from time to time chronicled how various Treasury and Federal Reserve interventions have produced unintended, undesirable consequences.

The latest example: the Fed’s efforts to push Treasury rates into ZIRP-land is reducing the incentives of traders to repo Treasuries to each other. That then reduces liquidity in the Treasury market.

Consider the boldfaced statement from a Financial Times article:

When rates tumble to low levels, it reduces the economic incentive to lend securities. The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close.

The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year.

“Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries,” said Michael Cloherty, strategist at Banc of America Securities. “We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.

“In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern.”….

“The zero per cent interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market,” said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.

Fails to deliver are another side effect.

Topics: Credit markets, Federal Reserve

Email This Post Email This Post Posted by Yves Smith at 5:40 am

13 Comments » Links to this post

13 Comments:

  • baychev says:
    December 17, 2008 at 6:20 am

    i think that the fed has overlooked this consequence of their action. at the same time they do not care even the slightest bit about the repo market: they will monetize the treasuries and keep them to maturity, or swap them for trash.
    would not be surprised even if treasuries become legal tender for debt settlement.

  • Gentlemutt says:
    December 17, 2008 at 8:52 am

    heh, heh, the only thing we can be certain of is that the USA will *not* repeat the monetary tightening of the Great Depression. That and that alone seems to be all that Mr. Bernanke can reliably achieve.

  • Bob_in_MA says:
    December 17, 2008 at 8:54 am

    With money market funds going to 0%, I imagine a lot of money will be going into CDs available at most brokerages.

    I assume money market outflows would mean less liquidity in the commercial paper market, or that the Fed will take up even more slack there.

    What about the Fed buying asset-backed debt, if they restrict it to AAA/AA debt, will it make any difference?

  • Anonymous says:
    December 17, 2008 at 9:54 am

    What about the yen carry trade?
    With this small difference in interest rates the trade does not (so much) justify the risk.
    That drains liquidity too.
    Gunther

  • Karl Smith says:
    December 17, 2008 at 12:22 pm

    I am not sure I get what is going on here.

    So, there is less incentive to use treasuries a collateral in repurchase agreements – do I have that right?

    Why is that first? Why does the interest rate paid by the asset matter?

    Second, less repos hurts liquidity. That makes sense. But how could this outweigh the effects of more reserves?

    Couldn’t you replace repos with a line of credit from a deposit institution and secure the line of credit with treasuries?

  • Anonymous says:
    December 17, 2008 at 1:44 pm

    Just another reason why you should never put an academic, like Bernanke, in charge of anything in the real world.

  • FairEconomist says:
    December 17, 2008 at 2:09 pm

    I know I’m starting to be a broken record, but it’s very simple. At 0% there’s no reason to lend – not for repos, not for deposits, not for money markets, not for anything. No lending, nothing to borrow. A liquidity trap is a liquidity trap, and the fact that Bernanke wants it to be stimulatory doesn’t change the fact that it will destroy the credit market.

    To make an analogy, low interest rates are a stimulant. But if you overdose on a stimulant, you die and the stimulant doesn’t help anymore. 0% is the death of credit. The Fed should have gone to quantitative easing at 2% at the lowest.

    Gentlemutt, you may be surprised. The money supply might well contract at this point due to the liquidity trap plus debt deflation plus general deflation. If the liquidity trap really sets in the Fed will have to print enough cash to replace almost all of M2 – over 5 trillion, as against 900 billion out there now. I don’t think Bernanke has the nerve to do that, partly because it would condemn us to a massive inflation once we were out of the trap.

  • Sivaram Velauthapillai says:
    December 17, 2008 at 3:04 pm

    FairEconomist: “I know I’m starting to be a broken record, but it’s very simple. At 0% there’s no reason to lend – not for repos, not for deposits, not for money markets, not for anything. No lending, nothing to borrow.”

    IANAE but I don’t see the logic in what you are saying. Why would you say that there is no interest in lending if rates fall? I personally think that it would induce more people to lend. Maybe not to the government at almost 0% but to others at higher rates. I think dropping the rates to 0% will induce savers and investors to shift up the risk curve and start buying non-govt bonds (this is basically lending), stocks, real estate, etc.

  • FairEconomist says:
    December 17, 2008 at 3:31 pm

    The specific problem with a liquidity trap is short term loans to high-quality intermediaries like banks and money market funds. At 0% there’s no reason to deposit short-term funds, so the banks and money market funds have nothing to lend. Nothing to lend so no interest in lending.

    You can see this operating in the higher-risk markets like A2/P2 and junk bonds. Even though interest rates on most cash equivalents is at or approaching 0, high-risk spreads are at records and volumes are low. Cash has to be secure and is only loaned to top-quality borrowers. Those borrowers (normally) then assume the credit risk to everbody else. But right now they’re not getting cash to make loans with.

    In our case all the problems are magnified by overpriced assets. Assets are overvalued; everybody knows that (although many with assets pretend otherwise) and so that adds a huge premium to all credit risks.

  • Anonymous says:
    December 17, 2008 at 4:40 pm

    “In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern.”

    Why is this a concern? We have low trading volumes in repo because repo rates are low. At the same time, Treasury rates are also low which makes it cheaper for the Treasury to finance. This increases the supply of Treasury collateral, increases repo rates, and improves repo market functioning.

    I don’t get what the FT is trying to say here, at least from a market functioning perspective. Unless they’re asserting that the Treasury’s financing need is insufficient.

  • sandi rubinspan says:
    December 17, 2008 at 7:33 pm

    IMO, Fairvalue is right.

    The Fed continues treating savers like two dollar wall street whores while treating the two dollar wall street whores like savers.

    The treasury markets will begin to disappear at 0 pct interest. The Fed has been forcing people into the hands of the merchants of risk for the last 8 years. This is one of the principle causes of this mess. Here we go again.

    Sandi Rubinspan

  • Irene says:
    December 18, 2008 at 5:09 am

    I also agree with FairEconomist on this one.

    Would also add that the comparison with the Japanese case seems quite inappropriate.

    Once they hit ZIRP, monetary policy for the BoJ became an FX policy to prevent yen appreciation. Domestic liquidity was generated straight out of export revenues. That mechanism stabilized the system for a long time due to the large trade surplus.

    In the US instead, there is a large trade deficit which naturally applies negative pressures on the exchange rate. Not only, the unwind of decades of yen-carry trade compounds that.

    I can’t see what will keep ZIRP in the dollar from causing hiperinflation. Zero rates per se are unstable for an economy that is not entirely export driven.

    ZIRP makes sense only as a temporary move toward substantial negative interest rates [i.e. capital taxation]. That would be a stabilizing solution. There are talks about it in Japan now . But I wonder whether anyone is considering this possibility seriously in the US.

  • River says:
    December 18, 2008 at 5:16 am

    Sandi and Fairvalue are correct. Today Ben destroyed what was left of money markets. Withdrawals will skyrocket, not that they were stable before. Once statements hit home mailboxes showing loss of principal it’s all over for money market funds. Ben has crossed the Rubicon.

    I see a blow up coming in treasury issues, even though Ben will print and issue like crazy to try to prevent it. If a treasury implosion happens the credit and budget of the US will be destroyed. I cannot imagine the consequences of such an event. In time maybe my brain can think about it but now I don’t want to go there.

    Be a good boy/girl scout and ‘be prepared’ as best you can.

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