General collateral rates have stayed above federal funds for most of the past month, with G.C. rates averaging 3 basis points above fed funds since February 15 due to the large amount of bill issuance since the end of February. At the same time, G.C. experienced significant volatility and even traded negative (-.01%) on Tuesday, March 12. The abundance of Treasury collateral is about to change with the April 15, April 18, and April 25 Cash Management Bills maturing over the next few days and I expect G.C. to drop below fed funds.
Collateral Shortage Update
The April seasonal collateral shortage is about to strike. Over the next two weeks, there is a net decrease in collateral supply due to bill maturities as follows: April 15 a net $25 billion maturing, April 18 a net $35 billion maturing, and on April 25 a net $39 billion maturing for a total of $99 billion.* That supply of collateral is disappearing from the market and going back to the Treasury.
Normally, the seasonal April collateral shortage stretches out into the middle of May, though it can be as short as two weeks and it even extended once into July. This year I expect a short collateral shortage. On April 30, the new 2 year, 5 year, and 7 year notes will settle and create a net $54 billion in Treasury collateral coming back into the market. That means about 54% of collateral that disappeared on April 15, 18, and 25 will return to the market in the form of notes. Given this, and combined with month-end funding pressure, the collateral shortage will likely end on April 30.
Over the past year, G.C. has diverged from its trading pattern on quarter-end. Since June 2012, G.C. averaged 15 basis points above fed funds on quarter-end, whereas in all of 2011 G.C. generally averaged flat to fed funds. I attribute this to an abundance of Treasury collateral – too much collateral in fact – in 2010 and then again in 2012. What would make loans collateralized with U.S. Treasurys trade higher than uncollateralized bank loans (fed funds)? Massive U.S. Treasury issuance. Would would temporarily bring the G.C./fed funds spread back down to trading float in 2011? The answer is QE2. From November 2010 through June 30 2011 the Fed purchased over $600 billion in Treasurys, taking that collateral out of the market. The effects of those purchases can be shown in quarter-end funding. During and after the QE2 program, the spread between G.C. and fed funds returned to close to flat. But as the large amount of Treasury issuance continued, G.C. rates rose higher than the fed funds rate to reflect the continued issuance and growing over-supply of Treasury collateral by 2012. Since the Treasury began QE3 and QE4, G.C. has continued to trade well over fed funds on quarter-end, but while the $85 billion in Fed purchases continues each month, G.C. should move to trade flat to fed funds over quarter-ends again soon.
The March Market Sell-Off
The “March Market Sell-Off” this year goes to . . . Cyprus. [see Market Commentary from February 26]. The surprise debacle caused a sell-off in many European markets also generated a flight-to-quality into U.S. Treasurys.
The 10 year note (2.0% 2/23) experienced a significant short squeeze with increased fails leading up to its first reopening on March 15. Fails at FICC (Fixed Income Clearing Corp) reaching over $78 billion on Monday, March 11, which prompted the Federal Reserve to call for Primary Dealers to submit “large position reports.” The Fed will occasionally examine dealer books when there is a shortage of a security to be sure no one is unfairly holding supply out of the market. The last time “large position reports” were called it was in February 2012.
The 10 year note had recorded impressively low Repo rates during the week before the reopening, with overnight rates trading as low as -3.75%, -3.35%, -3.40%, and -3.25%. With the Fail Charge set at -3.00% and the 10 year note trading below the Fail Charge, it prompting some market participants to question why someone would pay an extra 75 basis points to book a trade which might not even settle when they could just have an uncovered fail and accept the charge of 300 basis points. The answer is that sometimes there are other costs associated with fails which are not completely economic. There are increased operational costs, regulatory net capital charges, timing differences in booking the interest revenue versus interest expense, and potentially most of all, the cost of having to explain to your boss why you’re not covering all the firm’s short positions.
On March 15 all the fails cleared up and the 10 year note ended the day trading close to general collateral. Since March 15, the 10 year note has remained the strongest performing “special” on the curve, with a drop in Repo rates over quarter-end and another drop before the second reopening. Since more supply was added to the market in the second reopening, it is very unlikely that a triple 10 year note issue will ever trade special again.
Even with all the push-back from the Fed, the tri-party actually grew the past year. According to The Financial Times,*** the size of the tri-party market grew by 10% and now stands at $1.83 trillion. In addition, the use of non-government collateral also grew. Investment grade corporates, high-yield corporates, equities, CDOs, whole loans, and municipal bonds funded in tri-party are up to $296 billion, an increase of 15% in the past year.
In December 2012, the Fed released comments on Dodd-Frank Section 165 which weren’t pretty for the Repo market, especially for foreign banks with U.S. Repo market activity. Section 165 describes the relationship between large non-U.S. bank branches with over $50 billion in assets and their parent bank. Beginning in July 2015, any foreign bank with a broker-dealer subsidiary will be required to be rolled up into an intermediate holding company. All in all, it will require foreign banks to move more capital into their U.S. branches so that institution can last a month under a “stress funding situation.” Given the existing strain on capital at European banks, instead of moving more capital into the U.S., the banks may, instead, shrink their U.S. broker-dealer operations. If this is the case, it would mean less “market making” activities in the Repo and stock loan markets.
The Obama Budget
The Obama Administration submitted a budget to Congress which could have a direct impact on the Repo and stock lending markets. The budget included a proposal to change the tax treatment of derivatives by forcing investors to pay tax on unrealized derivatives gains. Currently, that tax is paid when the contracts mature and the gains or losses are realized. The new procedure would effectively require financial firms to mark-to-market derivatives for tax treatment and according to the Financial Times** the new tax could affect stock lending/borrowing, which means it would also affect the Repo market. However, I don’t expect the budget nor the new tax to pass the House.
* ICAP Wrightson; April 15, 2013
** Financial Times; “Tax plan risks equity options” 4/11/13; Page 13
*** Financial Times; “Repo market expands 10% in search for higher yields”; April 16, 2013