June 26, 2012 / 5:46 PM / 7 years ago

MONEY MARKETS-Repo rates up on Twist, may ebb near term

NEW YORK, June 26 (Reuters) - The cost for banks to borrow short-term funds backed by Treasuries has been trending higher as the Federal Reserve’s Operation Twist program adds to a surplus of short-end debt supply.

Analysts noted, however, that a number of other factors could stem the funding cost increases in coming weeks, at least temporarily.

The U.S. central bank said last week that it will extend the Twist program by another $267 billion, until the end of the year. Twist involves selling short-term notes to fund purchases of long-dated debt, in a bid to lower consumer borrowing costs.

This supply has flooded the short-term rates market and is likely to help to continue to drive up the cost of borrowing overnight funds using short-term Treasuries as collateral.

“The extension of Operation Twist will result in some continued pressure on repo rates on the margin because it’s going to mean more competing supply in the front-end,” said Brian Smedley, interest rate strategist at Bank of America in New York.

Average overnight rates in the interdealer market have increased to 22.5 basis points in the last month, and analysts see this likely to increase to the mid-20s level. The rate had traded at around 10 basis points last October.

Analysts at Barclays also attribute some of the rise in the rates to new, possibly lower-rated banks adding market share in the market as the Federal Reserve pressures the industry to reduce risks posed by the dominance of three large banks.

Other factors in the coming weeks could stem rate increases, however, even if only temporarily.

Some banks have been using repo to secure extra cash cushions in recent weeks as Greek elections and bank downgrades by Moody’s Investors Service threatened new volatility. With these events now over, the banks may reduce these positions.

“In the last month or two it appears that some banks have built up a bit of an excess liquidity buffer leading up to the Greek elections and Moody’s downgrades, and that has contributed to some upward pressure on repo rates,” Smedley said.

“In the coming weeks we’ll see if banks feel more comfortable trimming back that excess liquidity,” he added.

Decreasing appetite heading into quarter-end at the end of this week could also reduce pressure in the market, adding to a temporary decline in rates.

Longer term, a deteriorating economy could push repo borrowing rates back down if the Fed launches new quantitative easing to further stimulate growth.

Some economists expect the Fed could launch a third round of easing, focused on purchases of mortgage-backed bonds as soon as its meeting in September.

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