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.
A smoothly functioning repo market 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 collapse of Lehman Brothers Holdings Inc., whose bankruptcy in September of that year plunged markets into a crisis, was 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, Fla., 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.
Repo rates have been most prone to go negative, a situation known as specials in the market, in the days preceding an auction as traders who previously sold the debt seek to buy the securities to cover those positions.
In this week's note and bond sales, the U.S. plans to auction $27 billion of three-year Treasuries tomorrow, $21 billion of 10-year debt on July 9 and $13 billion of 30-year securities July 10.
Signs of dysfunction are coming at a sensitive time for markets. The Fed is paring its stimulus and futures show traders expect the central bank may start raising interest rates in the middle of next year.
The concern is that dealers, which have pared inventories to meet more-stringent capital requirements required by the 2010 Dodd-Frank Act mandated by the Volcker Rule and Basel III, won't have as much capacity to handle any surge in volumes or volatility.
Securities Industry and Financial Markets Association data show the average daily trading volume in Treasuries has fallen to $504 billion this year from $570 billion in 2007, even though the amount outstanding has risen to more than $12 trillion from $4.34 trillion.
Bank of America Merrill Lynch's MOVE Index, a measure of expectations for swings in bond yields based on volatility in over-the-counter options on Treasuries maturing in two to 30 years, reached 52.7% on June 30, almost a record low.
The Fed is partly to blame. Through its policy of quantitative easing, it now owns about 20% of all Treasuries, or $2.39 trillion. Banks hold $547 billion of Treasury and agency-related debt.
In addition, the Fed's holdings have shifted in ways that leave fewer central-bank-owned Treasuries available to be borrowed. The shifts were caused by Operation Twist during the November 2011 to December 2012 period when the Fed sold shorter- dated Treasuries and bought more bonds, plus self-imposed central-bank restrictions on holdings of specific maturities.
The Fed's lack of certain holdings “appears to be driving the surge in fails, which has been concentrated in the on-the- run five- and 10-year notes,” Joe Abate, a money-market strategist in New York at primary dealer Barclays Plc, wrote in a note to clients on June 27. On-the-run refers to the most recently issued Treasuries of a specific maturity.
While the Fed has sought to cut risk in the repo market since the crisis, it still sees the chance that rapid sales of securities, known as fire sales, could disrupt the financial system. Fails reached a record $2.7 trillion in October 2008.
Repos are also important to the Fed because it has been testing a program in the market that is seen as a potential tool to withdraw some of its unprecedented monetary stimulus.
Eric Pajonk, a spokesman at the New York Fed, decline to comment on the Fed's reaction to the movements in recent weeks in the repo market.
The amount of securities financed daily in the tri-party repo market has declined 18% an average $1.60 trillion May, from $1.96 trillion in December 2012, data compiled by the Fed show. In a tri-party agreement, one of two clearing banks functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry's clearing banks.
Another difficulty in the repo market has been the decline in Treasury bill supply, with the U.S. having sold $264 billion fewer short-term bills in the April-through-June period than those that matured, according to John Canavan, a fixed-income strategist at Stone & McCarthy Research Associates in Princeton, New Jersey.
“The repo market itself provides lubricant to the entire Treasury market,” he said in a July 3 telephone interview. “Bills are a key lubricant to the repo market, and the supply of bills has fallen sharply. If this situation were to continue longer-term, it would be a more substantial problem.”