Bloomberg News

Fed’s Re-Twist May Lift Treasury Repurchase Agreement Rates

June 22, 2012

The Federal Reserve’s plan to extend its Operation Twist program through the end of the year may drive rates for borrowing and lending Treasuries above the top of the central bank’s target range.

Rates in the repurchase-agreement market have risen since the Fed last year began swapping short-term debt for longer-term Treasuries on its balance sheet to extend the average maturity of its holdings and buoy economic growth by keeping long-term borrowing cost low. ICAP Plc, the world’s largest inter-dealer broker, projects that so-called general collateral overnight Treasury repo rates will trade above 0.2 percent for all of July, reaching as high as 0.27 percent at month-end. The rate opened at 0.29 percent today.

The need for Treasury dealers to finance a record amount of short-term Treasury debt on their balance sheets, amid purchases of debt sold by the Fed, has created a glut of Treasuries in repo, driving rates upward. This trend will continue as the Fed sells and redeems $267 billion in debt with maturities of 3.25 years or less through year-end, according to primary dealers ranging from Royal Bank of Scotland Group Plc to Jefferies Group Inc. Dealers use repos to finance holdings and boost leverage.

“If dealers continue to add to their already record holdings of Treasuries, as the Fed continues Twist, GC repo rates should grind higher,” said Jim Lee, head of U.S. derivative strategy at Royal Bank of Scotland’s RBS Securities unit in Stamford, Connecticut. “The rise in repo rates is clearly not a good thing as it increases dealers’ financing costs.”

Dealer Holdings

The average rate for borrowing and lending Treasuries for one day through repos climbed to an over 10-month high of 0.275 percent on June 15, up from minus 0.001 percent on Dec. 30, a Depository Trust & Clearing Corp. general collateral finance repo index shows. The measure rose to 0.203 percent yesterday.

As of June 13, the 21 primary dealers that trade directly with the Fed held a record $73.3 billion of Treasury coupon securities due in three years or less, up from $1.8 billion on Oct. 5, Fed data show.

A repo typically involves the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender. Treasuries that can be borrowed at interest rates close to the Fed’s target rate are called general collateral. Those in highest demand have lower rates and are called “special.”

General Collateral

The DTCC index is a weighted average of all general collateral repo transactions during a day. The DTCC processes about $3.6 trillion in repos transactions daily.

The central bank said it would prolong the program, originally scheduled to end this month, through the end of the year to further reduce borrowing costs and lift growth, according to a June 20 statement following a two-day meeting of the Federal Open Market Committee in Washington.

“There should be continued upward pressure on repo rates, with possible periods of temporary increases above 25 basis points” the top of the Fed’s target range, said George Goncalves, head of interest-rate strategy in New York at Nomura Holdings Inc., a primary dealer. “This should catch market attention and reduce investors doing carry trades in cash Treasury products. If the money-market frictions become permanent, it could start to push up the London interbank offered rate.”

Carry Costs

Higher repo rates increase the so-called carry costs for buyers of the debt. The 0.30 percent yield on the benchmark two- year Treasury note was 14 basis points more than the overnight general collateral repo rate. About a year ago, the two-year yielded 47 basis points more. Carry costs, the rate of interest earned from debt purchased less the cost of the funds borrowed to buy them, rise as the gap narrows. The rate on a one-year Treasury bill was 0.17 percent, about matching GC repo.

In the Twist through year-end, the Fed will purchase $267 in outright Treasuries and Treasury Inflation Protected Securities, known as TIPS, with maturities of six to 30 years, according to the Federal Reserve Bank of New York website. The central bank will finance those purchases, which will leave the size of its balance sheet unchanged, by redeeming or selling an equivalent amount of short-term debt.

“Additional Fed Twist does pose a threat to causing repo rates to move higher, but it’s not a given,” saidIra Jersey, an interest-rate strategist at primary dealer Credit Suisse Group AG in New York. “Dealer positions longer than three years, which are beyond the scope of Twist, have increased $25 billion since early February, while holdings of coupon securities shorter than three years have increased only $5 billion.”

Fed Funds

The FOMC has kept the main interest rate in a range of zero to 0.25 percent since December 2008. The three-month London interbank offered rate, or Libor, which represents the rate at which banks say it would cost to borrow from another, was at 0.46160 percent today, down from 0.46760 yesterday, according to the British Bankers’ Association.

The rise in overnight repo rates has caused the federal funds rate to drift higher, even as the central bank has extended their commitment to keep rates near zero.

The Fed Fund effective rate, a volume-weighted average on trades by major brokers published daily by the New York Fed, was at 0.17 percent on June 21, up from 0.04 percent at the end of last year.

On Hold

Fed Policy makers in the statement repeated their view that economic conditions will probably warrant keeping interest rates “exceptionally low” at least through late 2014.

The fed effective rate has also drifted higher as trading in overnight cash dwindles. Daily bank demand for fed funds, which historically helped keep the effective rate near the target, has slid as reserves at the central bank surged after asset purchases to spur growth. Banks’ excess reserves at the Fed were $1.49 trillion as of June 13, versus $2.2 billion in 2007.

The average overnight Treasury general collateral repo rate averaged 0.19 percent yesterday through 10 a.m. New York time trading, when most trading takes place, according to ICAP. The morning average rate was 0.17 percent the day before.

“The rise in dealer positions in Treasuries has basically moved in a straight line up to a record since the Fed began Twist last year,” said Thomas Simons, an economist in New York at Jefferies Group. “The continuation of Twist will have an incremental effect on dealer holdings and the amount of collateral that gets pushed into the repo market. That would lead to slightly higher repo rates going forward.”

To contact the reporters 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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