Bloomberg News

Money Market Investors May Get Relief From Fed’s Operation Twist

September 28, 2011

Sept. 28 (Bloomberg) -- Investors in U.S. money market funds may get some relief from record-low returns when the Federal Reserve begins to sell short-term debt as part of its latest stimulus effort that’s been dubbed Operation Twist.

The rate to borrow and lend Treasuries for one day in the repurchase agreement market may rise six to eight basis points, according to Barclays Plc. Overnight general collateral repo agreements for Treasuries averaged 0.069 percent since June, while one-month Treasury bill rates averaged 0.0113 percent. The one-month bill has traded below zero almost every day since mid- August.

The Fed’s plan to begin selling $400 billion of Treasuries due in three years and less next month to fund purchases of a similar amount of longer-maturity debt comes as investors park cash in money funds. Investors have been seeking a refuge from Europe’s debt crisis and slowing growth. Custody banks have also been hurt by persistent low interest rates, which reduce income from lending cash and securities and cut fees from the funds. Bank of New York Mellon Corp., the world’s largest custody bank, said last month it will begin charging customers for “extraordinarily high” cash deposits.

“A significant portion of the Fed’s sales of shorter-dated holdings will ultimately find a home with money market funds,” Kenneth Silliman, head of U.S. short-term rates trading at Toronto Dominion Bank’s TD Securities unit in New York, said in a telephone interview. “Money funds have been desperately seeking Treasuries with a positive yield.”

Money Flows

Demand for short-term government debt instruments has risen this year as the supply of Treasury bills fell due to reduced government sales, causing money market rates to trade below zero. The Fed has kept its benchmark rate for overnight loans at near zero percent since 2008 and purchased assets to lower long- term rates.

During the six-week period ended Sept. 20, money-market mutual funds took in $66 billion, according to research firm Crane Data LLC, based in Westborough, Massachusetts. Total assets in the funds rose to $2.59 trillion, including $2.3 trillion in taxable and $1.46 trillion in prime funds.

One-month Treasury bill rates averaged negative 0.0035 percent over the last month. Two-year Treasury note yields have risen to 0.24 percent from 0.20 percent on Sept. 21, the day the Fed announced its latest debt purchase program.

The influx of securities from the Fed’s sales may cause repo rates to rise six to eight basis points through June, according to Joseph Abate, money-market strategist in New York at Barclays, one of the 20 primary dealers that trade government debt with the central bank. The Fed purchases as slated to be completed in June.

General Collateral

The fall in bill supply, as the Treasury stopped sales of bills on behalf of the Fed, also cut the amount of Treasuries available in the repurchase agreement markets, pushing Treasury repo rates lower as investors grew more willing to take lower interest rates on loans to get needed securities.

The average overnight general collateral repo rate was 0.1 percent as of 10 a.m. New York time yesterday, when most trading takes place, according to ICAP Plc, the world’s largest inter- dealer broker. The rate fell to as low as 0.001 percent on July 6, matching the lowest since the January 2010. The rate was as high as 0.22 percent on Jan. 3.

Securities dealers use repos to finance holdings and increase leverage. Securities that can be borrowed at interest rates close to the Fed’s target rate, which now is in a range of zero to 0.25 percent, are called general collateral. Those in highest demand have lower rates and are called “special.”

Effective Rate

The volume-weighted average for trades of overnight federal funds, known as the fed effective rate, averaged 0.09 percent over the last month. That’s within the Fed’s target rate for overnight loans between banks of zero to 0.25 percent since December 2008. The Fed pays banks a 0.25 percent rate on excess reserves they hold at the central bank.

U.S. money funds reduced lending to European banks further last month, with the biggest U.S. funds cutting their holdings to the lowest in at least five years, as the region’s sovereign debt crisis worsened. The 10 biggest U.S. funds eligible to purchase corporate debt, with a combined $676 billion in assets, reduced European bank assets to 42 percent of holdings, the lowest level since at least 2006, Fitch Ratings said in a Sept. 23 report.

“The Fed’s sales of shorter-maturity coupons will make some supply available to Treasury-only money market funds, which are a massive buyer of bills and investor in Treasury repo,” Michael Cloherty, head of U.S. interest-rate strategy in New York at Royal Bank of Canada’s RBC Capital Markets, said in an telephone interview. “When the Fed sells a short-term security, it means that when it matures the Fed won’t have any paper to roll over at the Treasury auctions,” which will cause the Treasury to receive less money at its auctions than it otherwise would.

The Treasury will need to raise auction sizes to offset that drop in cash, added Cloherty, who said that given the bills are at a historic low percentage of the Treasury’s total debt, they are most likely to get a greater share of any increase in issuance.

Treasury bills as a percentage of the government’s total debt portfolio have fallen to 16 percent as of June 30, down from as high as about 35 percent in the fourth quarter of 2008, and an average of 24 percent from 2000 through 2007, according to Treasury Department data.

--With assistance from Christopher Condon in Boston. Editors: Dave Liedtka, Paul Cox

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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