MONEY MARKETS-Dealers turn to Fed for bonds as repo rates turn negative

Tue Jan 29, 2013 12:40pm EST

* Low repo rates discourage big securities lenders

* Dealers borrow bonds from Fed to cover short positions

* Repo rates seen rising after this week's bond auctions

By Karen Brettell

NEW YORK, Jan 29 (Reuters) - The amount of bonds Wall Street dealers are borrowing from the U.S. Federal Reserve surged in the past two weeks due to a scarcity of certain Treasuries issues in the repurchase agreement market.

The scramble came after large lenders of the securities moved to the sidelines, as they were being paid less due to a dramatic drop in yields earned on lending bonds in the repo market.

Repo rates have plunged in the past month, with rates on certain Treasuries issues turning negative. This means a firm would pay interest to lend a Treasury bond, instead of receiving interest under normal market conditions.

The cost to borrow funds in the $5 trillion repurchase agreement market against general collateral has plunged since year-end, dropping from near 30 basis points.

The decline has led securities lenders, who get paid to lend the bonds, to back away as returns are less attractive. In response, investors who are short Treasuries are now turning to the Fed instead to borrow the notes and cover their positions.

"We think that late in the day dealers are using the Fed more than they have been to cover shorts," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

Dealers can borrow debt from the Fed for themselves or for clients for 5 basis points, and in return for other bonds being posted to back the loans.

The wave of shorting in Treasuries manifested in benchmark yields hitting 2 percent early Monday, which was the highest level in nine months, before they retreated in late trading.

Investors have been betting that Treasuries yields will rise in the wake of encouraging U.S. economic data and signs of a healthier banking system in Europe.

According to a J.P. Morgan survey released on Tuesday, 25 percent of the firm's clients said they held fewer Treasuries than their portfolio benchmarks, which was the highest level since July 2011.

Some see repo rates rising by next week, however, as dealers receive their purchases of new Treasuries supply for sale this week.

The U.S. Treasury Department is auctioning a combined $99 billion in two-year; five-year and seven-year debt this week.

The amount of notes borrowed from the Fed rose to $21 billion on Monday, the highest level since March, and up from $6 billion on Jan. 17.

Of those notes, three-quarters of notes lent by the Fed on Monday were in the seven-year sector, maturing from late 2019 to early 2020.

Analysts attributed much of the demand for seven-year paper to a scarcity of supply as the U.S. central bank buys bonds as part of its latest quantitative easing program to stimulate the economy.

"Most of what the Fed lent out yesterday was in the seven-year sector; the Fed has been buying a lot of that paper," said Ira Jersey, an interest rate strategist at Credit Suisse in New York.

Repo rates had risen last year as the Fed sold short-dated debt as part of its Operation Twist program, in which proceeds from the sales were used to fund longer-dated bond purchases.

These sales stopped at the end of the year, while investors, including government money funds, this year have had inflows and have sought greater investment in the sector.

"You have a ton of cash out there and that cash has to be put to work," said Jersey.

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