June 7 (IFR) - A key overnight interest rate went negative twice last week, in a rare stumble that renewed attention on the distortions created by the Federal Reserve’s asset-buying stimulus program.
The overnight general collateral repo rate, or GC rate, effectively determines the interest earned on overnight secured loans to banks.
A negative rate means lenders pay for the privilege of loaning money - an unsustainable position that has highlighted severe dysfunction in the so-called repo market.
The GC rate fell to negative three basis points (bp) last Wednesday, and dropped two more bp the following day - its first tumble into negative ground since the 2011 eurozone crisis.
That drop has renewed concerns that the repo market is clogged, with a shortage of the collateral it needs to function smoothly.
Using Treasury bills as collateral, banks turn to the overnight market to borrow short-term funds that finance their bond holdings and balance that day’s books.
By definition the rate is related to the value of T-bills, which along with the rest of the rates market, are in the midst of a weeks-long sell-off due to worries that the Fed will begin tapering its stimulus program.
“Seasoned veterans pay attention when the front-end of the Treasury curve starts percolating,” said Russ Certo, managing director and head of rates trading at Brean Capital.
“It can remain dormant for a long time. But when it percolates, it’s normally a sign of a lot of pent-up energy in the marketplace.”
The overnight loans in the repo market are the prime market for short-term investors and generate returns for lenders - many of which are money market funds - while allowing banks to use their inventories of collateral to finance their operations.
But the Fed’s QE program, in which the government buys up $45 billion of Treasuries and $40 billion of mortgage-backed securities (MBS) each month, is distorting that market.
The Fed’s asset purchases artificially soak up the pool of collateral that would make the repo market work smoothly, and thus end up pushing the overnight rate down.
Several rates traders said they have approached the Fed to express concerns about the issue, but have been met with a defensive stance - and little useful feedback.
Publicly, Fed Chairman Ben Bernanke said that he has increased his monitoring of market dysfunction at the hands of QE, indicating on May 22 that he was more concerned about this kind of financial instability than previously.
But that sort of acknowledgment has not kept pace with increasing grumbles in the market that QE has created asset-price bubbles - particularly in stocks - and badly distorted other sectors of the financial markets.
Bill Gross, the high-profile managing director of Pimco, the world’s largest bond fund, warned in his latest market outlook this week that the freeze in collateral caused by the Fed’s asset purchases is hurting the economy.
“The ability of private credit markets to deliver oxygen to the real economy is being hampered, because most new Treasuries wind up in the dungeon of the Fed’s balance sheet,” he said.
“Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury repo.”
Data from the Fed itself suggest that the collateral shortage for banks has become significant since the beginning of the year.
In total, the Fed’s System Open Markets Account (SOMA) - which serves as a backstop for market liquidity - is now regularly loaning banks more than $19 billion per day in Treasury notes to be used as collateral.
Between September 2012 and late January 2013, there were only four days when that figure exceeded $10 billion.
The problem is that there is too much cash in the market looking to be put to work - and not enough collateral to satisfy those trading needs.
If the situation becomes really dire, the Fed could reintroduce its Term Securities Lending Facility, according to some analysts. The TSLF was a weekly loan facility introduced in March of 2008 during the height of the credit crisis to promote liquidity.
The program offered Treasury securities from the SOMA account to primary dealers as loans for a one-month term through competitive price auction, and was subsequently closed in February 2010 once it was deemed markets were liquid enough.
Others say the change in dynamics may only be temporary, as the US tax season always brings an onslaught of cash into the market in the following weeks.
What’s more, this year tax receipts came in stronger than expected, biting into the Treasury’s deficit and allowing it to lop US$200bn off its projected Treasury issuance for 2013.
The Treasury is about to issue $66 billion in three-year, 10-year, and 30-year notes set to settle on June 17, which should soak up some of the excess cash in the market.
But there is no guarantee the issuance will smooth out the market imbalance. Other factors at play include a wave of bank collateral requirements that will hit the market through the summer under new Dodd-Frank legislation.
“If you want to talk about collateral don’t look at what the Fed is doing, look at what Dodd-Frank is doing,” said one short-term rates trader at a major dealer.
Several hundred buy-side firms will be required to clear over-the-counter interest rate and credit default swaps starting on Monday.
Those firms will be required to post cash and high-grade assets as collateral against those positions - an entirely new condition that is expected to soak some 700 billion euros in assets out of the market, according to a study from the International Organisation of Securities Commissions.
“Generally, the broad trend of increased haircut capital and margin requirements in the global marketplace is going to create greater and greater need for high quality collateral,” said Brean Capital’s Certo.
International regulators will also impose capital and liquidity standards on primary dealers to protect against banks’ vulnerability to liquidity shocks, which is expected to create a further shortfall of 1.8 trillion euros, according to a 2011 Basel study of 209 banks.
The squeeze on short-term financing hinders a bank’s ability to carry out its normal operations. In the most extreme cases, it can lead to quick fire sales of assets that can hasten a bank collapse, as happened to Lehman Brothers and Bear Stearns during the financial crisis.
Officials have recently acknowledged that this is a concern.
Fed staff released a paper at the beginning of May examining fire sales in the tri-party repo market as part of ongoing efforts to secure the market after its role in the 2008 credit crisis and the collapse of Long Term Capital Management in 1998.
The paper warns that the current efforts being undertaken to make the market safer “will not mitigate the risk of fire sales”.
And the Treasury Market Practices Group - an industry group that advises the Treasury - released guidelines for the timely settlement of repo transactions on May 23, cautioning that a well-functioning repo market was “critical to the health and stability of the US financial markets”.