Investor bets on rising U.S. interest rates are testing the short-term cash markets that serve as the financial system’s plumbing.Hedge funds and other institutional investors are paying an annual rate of as much as 4% to borrow the most-recent issue of the 10-year U.S. Treasury note in the market for repurchase agreements, or repos. These hedge funds and others want to borrow and sell the bonds now in a wager that they can buy them back later for less, as rising U.S. rates push bond prices lower. The 10-year Treasury yield settled at 1.594% Monday, its highest level in more than a year, up from 0.913% at the end of 2020.
Usually, those hedge funds, central banks and other institutions lending in the repo market receive both Treasurys, which function as collateral, and interest payments in exchange for providing overnight cash. Now they are paying to borrow Treasurys and part with cash. The inversion—which last reached these levels a decade ago—has caught traders and investors off guard.
“The cost of borrowing securities has skyrocketed in the past few days as the market has been under enormous pressure,” said
U.S. rates strategist at TD Securities in New York.
The repo market shook the financial world in September when an unexpected rate spike choked short-term lending, spurring the Federal Reserve to intervene. WSJ explains how this critical, but murky part of the financial system works, and why some banks say the crunch could have been prevented. Illustration: Jacob Reynolds for The Wall Street Journal
The $1.3 trillion overnight repo market is where hedge funds, banks and financial companies borrow cash overnight from one another. This market exists to allow companies or investors that own lots of securities but are short on cash to cheaply borrow money. And it allows parties with lots of cash to earn a small return while taking little risk, because they hold the securities as collateral.
A September 2019 spike in the cost of borrowing in the repo market stemming from a scarcity of cash prompted the Federal Reserve to inject hundreds of billions of dollars into money markets.
Traders betting on higher U.S. rates want the most easily traded bonds for the purpose, which tend to be the most-recently issued 10-year notes. And to locate them, they lend money in the repo market and receive the bonds in return as collateral.
Usually, they would also get a small fee. Instead, expectations for an increase in interest rates in a post-pandemic, stimulus-fueled expansion have driven those fees to the lowest since 2003, when technical factors sparked a similar inversion. At those levels, it is cheaper to pay a fine for failing to complete the transaction.
Even though the Fed has said it plans to keep rates low for a long period, investors are concerned about inflation and the long-term effects of unprecedented fiscal policy.
While financial markets are flush with U.S. government bonds issued in recent years to fund tax cuts and pandemic relief, the concentrated demand for the most recently issued 10-year Treasury notes has created a supply shortage, according to traders and analysts. Speculative bets against the 10-year Treasury note last week posted their largest one-week increase on record in data compiled by TD Securities, suggesting increased demand for the $41 billion of 10-year notes issued in February outstanding.
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Some analysts expect the situation will ease this week after the U.S. Treasury’s scheduled auction of $38 billion in 10-year notes on Wednesday.
The expiration of a special exemption that allowed banks to hold less capital compared with the size of their balance sheets is also fueling some anxiety in funding markets, analysts said.
The exemption to the so-called supplementary leverage ratio rule allowed large banks to not count their holdings of Treasurys and central bank reserves when working out how much capital to hold to remain within regulatory limits. If the exemption expires on March 31, banks would have to hold more cash against Treasurys and deposits at the Federal Reserve. That could prompt them to cut holdings of U.S. government bonds, a step that many analysts contend would likely increase market volatility.
Regulators are expected to make a decision soon on whether to extend the special exemption, Fed Chairman
said in February. Some lawmakers in Washington have urged the Fed in recent months to let the exemption expire.
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com and Sebastian Pellejero at firstname.lastname@example.org
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