Today’s Bloomberg provides yet another example of how the credit crisis is producing behavior well outside historical norms. We had noted, courtesy Alea, that fails in the repo market had reached “massive” levels.
The explanation? A lot of Treasuries are now held by investors who aren’t willing to lend them (this is often due to simple lack of experience, plus retail buyers having failed to authorize the account to lend securities). I wonder if this has the potential to complicate the operation of the Fed’s new facilities designed to unfreeze the mortgage market. The Fed may be running into constraints beyond the size of its balance sheet (note technically it can make its balance sheet larger, but those operations would be “unsterilized” or inflationary).
The scarcity of Treasuries for repos means that buying for repoing will also lead Treasury prices to rise and yields to plummet, which is one reason why three month bills traded at an 50 year low of 0.56% yesterday and a stunning 0.39% today, a rate last seen in 1954.
Since bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the Treasure market have the potential to feed into other markets (we’ve already seen problems with new issue bond pricing due to sharp increases in spreads and blow-ups of correlation models in the credit default swaps market).
Surging demand for U.S. Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years.
Failures, an indication of scarcity, surged to $1.795 trillion in the week ended March 5, the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week this year, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to Federal Reserve Bank of New York data.
Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills today to 0.387 percent, the lowest level since 1954….
“It shows you the kind of anxieties that are going on and the keen demand for Treasuries,” said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York. “The rise in fails tells us about the inability of dealers to obtain Treasury collateral.”
In a repurchase agreement, or repo, a customer provides cash to a dealer in exchange for a bill, note or bond. The exchange is reversed the next day, with the customer receiving interest on the overnight loan. A Treasury security is termed on “special” when it is in such demand that owners can borrow cash against it at interest rates lower than the general collateral rate.
The Treasury Department cautioned dealers in January to guard against failing to settle in the Treasury repo market as interest rates fall. It cited periods of such failures to receive or deliver securities, known as `fails’ in the repo market, earlier in the decade when rates dropped.
The difference between the rate for borrowing and lending non-specific Treasury securities, or the general collateral rate, has averaged 63 basis points below the central bank’s target rate for overnight loans this year. The spread has averaged about 8 basis points the past 10 years.
Overnight general collateral repo rates have traded lower than the Fed’s target rate for overnight lending every day this year. The rate on general collateral repo closed today at 0.9 percent, according to data from GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker, compared with 1.25 percent yesterday. Today’s rate is 1325 basis points below the Fed’s target rate for overnight lending of 2.25 percent.
Investors’ unwillingness to hold privately issued mortgage- backed bonds amid record home foreclosures sent premiums on even Fannie Mae and Freddie Mac guaranteed assets to the highest in 22 years earlier this month. The two government-chartered companies are the biggest sources of U.S. housing finance.
The current rise in Treasury fails is similar to increases that occurred in August 2003, said George Goncalves, chief Treasury and agency strategist at Morgan Stanley in New York.
“At that time, short positions in U.S. Treasuries were building but interest rates were declining, and that led to a pick up in fails as a result,” Goncalves said. “It seems like we have a repeat in the making. This also explains why the repo markets are in flux.”
Treasury fails rose to a record $3.244 trillion in the week ended Aug. 20, 2003, the highest to date through July 1990, or as far back as the New York Fed tracks the data on its Web site. For the month of August 2003, the weekly average was $2.751 trillion.