Here we go again: Turbulence rocks the buyback market

Here we go again: Turbulence rocks the buyback market

by
Usually, these negotiations take place in the background, with little fanfare. But every now and then, the system breaks down, as it did in late 2019 and again a year ago. This is another one of those moments.

The 10-year Treasury bond lending rate in the repurchase market dropped to minus-4% this week, a very rare occurrence. This means that investors are basically paying to borrow on 10-year bonds, when it is usually the other way around.

Short crowded bets

With Wall Street economists dramatically raising their GDP estimates, investors have begun to place massive bets that Treasury rates will rise dramatically. One way to express this view is to short-sell Treasury bills. (When Treasury prices fall, their rates go up.) To carry out this operation, hedge funds are taking Treasury bills in the repurchase market, selling them and agreeing to buy them back, preferably at a lower price. low so they can pocket the difference.
Exclusive: Wall Street will have a rude awakening, says former New York Fed chairman

But these bets are creating intense demand in the buyback market for 10-year Treasury bonds that can be shorted.

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

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

‘Cat and mouse game’

Wall Street is essentially testing the Fed, pressing to see how far the central bank will allow rates to rise before it intervenes.

“It’s a cat and mouse game,” said Mark Cabana, head of fee strategy at Bank of America. “The market is challenging the Fed. The Fed is being a little bit shy and basically saying to the market, ‘Go fix this’.”

The new Wall Street Bogeyman: the bond market

But the Fed does not want to hinder the recovery or scare Wall Street.

If rates rise sharply, it will increase the cost of everything from mortgages and auto loans to high-risk bonds.

And US stocks plunged last week as Treasury rates soared. The same thing happened on Thursday, with investors frightened that the 10-year Treasury’s yield had risen well over 1.5% in comments from Fed chief Jerome Powell. Higher yields on ultra-secure government bonds would steal the thunder of riskier assets, such as stocks.

“It will reach a critical point where it will have negative consequences for the financial market,” said Cabana.

The debate overheating

Even so, higher rates would also signal that the US economy is finally returning to normal after more than a decade of slow growth and anemic inflation.

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

Dudley said that Treasury rates of 1.6% are “nothing” and expected earnings will eventually rise to between 3% and 4% – or even more.

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

Cabana said Dudley, whom he has respected since the time they worked together at the New York Fed, may be taking too much of an academic approach.

“The biggest risk to everything the Fed is trying to achieve in terms of spurring growth and achieving full employment is very high American interest rates,” said Cabana. “That would knock down the apple cart.”

The Fed’s Hotel California problem

When the repo market exploded in the fall of 2019, the New York Fed came to the rescue, promising to inject billions of dollars into the markets. So-called overnight repo operations successfully soothed the markets, until they exploded again during the pandemic shock last spring.

The Fed would probably like a non-interventionist approach this time, as it seeks to slowly withdraw from crisis mode.

However, Cabana does not think this will happen, in part because of the huge federal budget deficits created by the pandemic and efforts to revive the economy.

To finance the deficit, Washington needs to continue issuing Treasury bills – and the Fed has been the biggest buyer of those bonds. The Fed is buying about $ 80 billion in Treasury bills every month through its quantitative easing (QE) program.
Two of America's most powerful economic voices disagree about a tax on the super-rich

“The Fed will have to increase its presence in the markets. This is how it ends,” said Cabana.

One possibility is that the Fed may further intensify its already massive QE program. Another option is to revive 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 undo its emergency policies.

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

.Source