Here we go again: Turmoil rocks the repo market

The repo market, a murky yet crucial corner of Wall Street, is acting weird again. And the turmoil suggests the Federal Reserve may need to come to the rescue once more.

The Dow, GameStop and bitcoin steal a lot of headlines, but the repo market is vital to the functioning of modern finance. Trillions of dollars of short-term loans, known as “repos,” are traded each day.

Normally, these trades happen in the background, with little fanfare. But every once in a while, the system breaks down, as it did in late 2019 and again a year ago. This is another one of those moments.

The rate to borrow 10-year Treasuries in the repo market plunged to minus-4% this week, a very rare occurrence. That means investors are essentially paying to borrow 10-year bonds, when normally it’s the other way around.

So why is this happening? It’s a symptom of uncertainty over how fast the US economy will recover, how long the Fed will keep its emergency policies in place and the vast amounts of debt Uncle Sam has piled on during the pandemic.

Crowded short bets

With Wall Street economists sharply raising their GDP estimates, investors have started placing massive bets that Treasury rates will rise sharply. One way to express that view is to short Treasuries. (When Treasury prices drop, their rates go higher.) To carry out that trade, hedge funds are borrowing Treasuries in the repo market, selling them and agreeing to buy them back, ideally at a lower price so they can pocket the difference.

President of the Federal Reserve Bank of New York, Bill Dudley speaks during the Bank of England Markets Forum 2018 event at Bloomberg in central London on May 24, 2018. (Photo by Victoria Jones / POOL / AFP) (Photo credit should read VICTORIA JONES/AFP/Getty Images)

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But these bets are creating intense demand in the repo market for 10-year Treasuries that can be shorted.

“This turmoil is being caused by the bond market swinging around as people realign their views on the economy,” said Scott Skyrm, executive vice president in fixed income and repo at Curvature Securities.

The 10-year Treasury rate spiked to 1.6% last week, well above the low last March of around 0.3%.

‘Game of cat-and-mouse’

Wall Street is essentially testing the Fed, pushing to see how high the central bank will allow rates to rise before stepping in.

“It’s a game of cat-and-mouse,” said Mark Cabana, head of rates strategy at Bank of America. “The market is challenging the Fed. The Fed is being a little coy and basically telling the market, ‘Go sort it out.’”

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But the Fed doesn’t want to harm the recovery or spook Wall Street.

If rates rise sharply, it would raise the cost of everything from mortgages and car loans to junk bonds.

And US stocks tumbled last week as Treasury rates spiked. The same thing happened Thursday, with investors getting spooked that the 10-year Treasury yield climbed well above 1.5% on comments from Fed chief Jerome Powell. Higher yields on ultra-safe government bonds would steal thunder from riskier assets like stocks.

“It will reach a tipping point where it has negative financial market consequences,” Cabana said.

The overheating debate

Yet higher rates would also signal that the US economy is finally getting back to normal after more than a decade of slow growth and anemic inflation.

“They want the economy to overheat,” former New York Fed President Bill Dudley told CNN Business earlier this week.

Dudley said 1.6% Treasury rates are “nothing” and predicted yields will eventually climb to between 3% and 4% — or even higher.

“The bond market right now is a little bit unrealistic about their expectations for the Fed. They certainly want the Fed to stop this,” said Dudley, who was previously a top economist at Goldman Sachs. “And I think the Fed’s view is, no. We’re not going to stop this. This is normal. This is what happens when the economy looks like it’s going to actually recover.”

Cabana said Dudley, whom he respects from their time working together at the NY Fed, may be taking too much of an academic approach.

“The greatest risk to everything the Fed is trying to achieve in terms of stimulating growth and reaching full employment is too high US interest rates,” Cabana said. “That would tip the apple cart.”

The Fed’s Hotel California problem

When the repo market blew up in the fall of 2019, the NY Fed came to the rescue by promising to inject billions of dollars into the markets. The so-called overnight repo operations successfully calmed markets down, until they erupted again during the shock of the pandemic last spring.

The Fed would probably like to take a hands-off approach this time as it seeks to slowly retreat from crisis mode.

However, Cabana doesn’t think that will happen, in part because of the enormous federal budget deficits created by the pandemic and efforts to revive the economy.

To finance the deficit, Washington needs to keep issuing Treasuries — and the Fed has been the biggest buyer of these bonds. The Fed is purchasing about $80 billion of Treasuries every month through its quantitative easing (QE) program.

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“The Fed will have to increase its footprint in markets. That’s how this ends,” Cabana said.

One possibility is the Fed could further ramp up its already-massive QE program. Another option is reviving Operation Twist, a post-2008 crisis tool designed to suppress long-term rates.

All of this underscores how difficult it is for the Fed to unwind its emergency policies.

“It’s the Fed’s Hotel California problem,” Cabana said. “You can check out, but you can never leave.”