[Pen-l] Ultra-low US rates undermine repo market

["Jayson Funke" <jfunke@xxxxxxxxxx>]

Ultra-low US rates undermine repo market

By Michael Mackenzie in New York 
http://www.ft.com/cms/s/0/2da96724-cbb1-11dd-ba02-000077b07658.html

Extremely low short-term interest rates in the US are sharply eroding
the functioning of the government repurchase or repo market, a
foundation stone for the financial system and trading Treasury debt. 

While the Federal Reserve reduced its benchmark interest rate from 1 per
cent to a new range of zero to 0.25 per cent on Tuesday, short-term
market rates have been trading at close to zero per cent in recent
weeks. Driven by a flight to safety by investors and expectations of
rate cuts, such conditions are creating problems in the repo market,
where investors borrow Treasuries in return for short-term cash loans. 

This activity allows traders to sell Treasuries without owning them in
the first place, while owners of government debt can fund their
portfolios by lending Treasuries. 

When rates tumble to low levels, it reduces the economic incentive to
lend securities. The reduction in liquidity in the $5,800bn Treasury
market comes at a time when conditions have become strained as the
calendar year draws to a close. 

The problems also come as the US Treasury prepares to issue a massive
amount of new government bonds for the current financial year.

"Low rates are having a corrosive effect on the repo market, which will
impair liquidity in Treasuries," said Michael Cloherty, strategist at
Banc of America Securities. "We are getting close to a situation where
structural damage caused by low interest rates outweighs any benefit
from easier monetary policy.

"In a [financial] year where the Treasury is facing a net financing need
of roughly $1,800bn, lower trading volume is a major concern."

Problems in repo impair general trading across the Treasury market. A
rise in so-called failed trades, where a borrowed security is not
returned in a timely fashion, becomes a drain on the balance sheets of
dealers. Low interest rates are also hampering the ability of dealers in
financing positions by matching the different needs of clients, known as
matching offsetting trades. 

"The zero per cent interest rate environment is effectively eliminating
the dealer matched-book business and crippling dealer intermediation in
the repo market," said Scott Skyrm, senior vice-president at Newedge, a
repo broker dealer. 

Copyright The Financial Times Limited 2008



---------------------

Jayson Funke
Graduate School of Geography
Clark University
950 Main Street
Worcester, MA 01610


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