U.S. repo market signals still-higher rates on the way

06/25/2013

By Richard Leong

NEW YORK, June 25 (Reuters) - Bond yields have risen sharply in the last week, but some traders don't think the selloff is over as the market prepares for $99 billion in U.S. government bond auctions over the next three days.

One signal that traders expect higher yields comes from the key short-term borrowing rate known as the repurchasing rate, or "repo" rate. This $4 trillion market is key to the daily operations of Wall Street firms, which borrow cash daily through repos to finance their trades and operations.

Rates in this market have turned negative, part of the broader market turbulence stemming from fears of less Federal Reserve support. Negative repo rates underscore how traders could borrow a Treasury bond now and repay it later, because they could buy it back for a lower price if yields rise.

The Fed's announcement last week that it expects to reduce stimulus later this year if the economy shows further improvement caused investors to dump stocks, bonds and other assets, sending global shares tumbling and benchmark U.S. yields to 22-month highs.

"The sentiment has been very pessimistic. There are not too many people who are long the market," said Tom Simons, money market strategist at Jefferies & Co. in New York.

The auction of new government debt comes after the benchmark 10-year Treasury yield on Monday rose to 2.667 percent, highest since early August 2011 and the fastest weekly jump in a decade last week.

The U.S. Treasury Department will kick off the auctions on Tuesday with a $35 billion sale of two-year debt, followed by $35 billion in five-year notes on Wednesday and $29 billion in seven-year debt on Thursday. Clues to how traders are viewing these auctions can be seen in repo trading for those maturities.

Normally, Wall Street firms pay an interest rate - the repo rate - to a bank or a money market fund in exchange for a short-term cash loan (usually overnight). The dealers offer up collateral for the loan - normally a Treasury bond.

However, in recent days the market has shifted. There is a scarcity of Treasury securities right now because Wall Street dealers and hedge funds have started to short these securities. When traders short Treasuries, they are betting prices will fall and yields will rise.

As a result, for a bank or a money fund that needs to invest its cash to get their hands on a Treasury note, they now have to accept a lower rate - or in some cases, a negative repo rate. Thus, the bank or money fund, instead of being paid for lending out cash overnight, is paying to hold the security.

This has kept the interest rate on repos backed by certain Treasury maturities negative, or what's known as "special." It has been particularly acute in the issues that are being auctioned this week - the two-, five- and seven-year paper.

In Tuesday trading, the overnight rates on repos backed by two-year notes dipped further into negative territory, last traded at minus-60 basis points, versus minus-16 basis points on Monday. Repo rates backed by five-year Treasuries were quoted at minus 6 to 9 basis points, while repos rates backed by seven-year notes were quoted at zero to minus 4 basis points.

Some analysts downplayed the negative repo rates, linking them to this week's Treasuries supply. Bond dealers typically short Treasuries in the repo market to hedge against coming supply.

"Everyone is positioning themselves, going short into the auctions due partly to typical hedging ahead of supply," said Gennadiy Goldberg, interest rate strategist at TD Securities in New York.

Strong demand for these maturities should help stabilize the bond market here and abroad where yields followed the jump seen in the Treasuries market, but it is unclear whether investors will snap up this debt even at these higher yields.

In the "when-issued" market, traders expected two-year notes that will mature in June 2015 to sell at a yield of 0.4070 percent at 1 p.m. (1700 GMT), which would be the highest yield at a two-year auction since July 2011. The current two-year was yielding 0.388 percent.

"We are still kind of bleeding," Goldberg said.



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