Treasury Short Sellers Face Rising Costs to Borrow 10-Year Notes

The cost of borrowing U.S. Treasury 10-year notes continues to spiral higher despite record-size auctions, fueled by a growing pool of investors who want to bet on higher yields.

The interest rate on overnight cash loans backed by the newest 10-year note -- repurchase agreements, or repos -- plummeted below minus 3% Wednesday for only the third time since the beginning of 2018, according to Scott Skrym of Curvature Securities LLC. That’s the threshold below which it’s cheaper to pay a regulatory fine than to complete the transaction, and it’s an indication of huge demand to be short the issue after last week’s selloff pushed its yield to a one-year high.

While next week’s auction of additional 10-year notes may alleviate the pressure on repo rates, Treasury yields resumed rising Thursday, suggesting that bearish bets have room to run. The move began when Federal Reserve Chairman Jerome Powell downplayed the increase in long-term borrowing costs. In unscripted comments on the economy and monetary policy, Powell waved off the idea that the central bank ought to extend the average maturity of its purchases of Treasury securities, as some Wall Street strategists have suggested.

Next week’s auction “should help, but we have a week to go,” John Davies, U.S. interest-rate strategist at Standard Chartered Plc, said of the March 10 auction. “The intervening period could still be very volatile for Treasuries and the pressure in the repo market could well remain in place.”

Liquidity Crunch

The past week’s turmoil in Treasuries has been marked by a drop in liquidity, which has prompted borrowers to opt for the more-liquid current 10-year Treasury over older notes in the sector that would be cheaper to borrow. The negative interest rate means the investor lending cash to borrow the note ends up having to pay, instead of getting compensated, and it suggests there’s a large short position in the security. The general collateral repo rate, by contrast, closed at 0.03% Wednesday.

Daily Treasury repo fails -- which become a cheaper option than covering a short position when the repo rate falls below negative 3% -- surged to $64 billion as of March 3, the highest in four months, according to DTCC. Meanwhile, the rate to borrow the 10-year security in the repo market reached a low of minus 4.25% on Thursday, according to Curvature’s Skrym.

Another illustration of high demand to borrow the newest 10-year note is that the Fed, which owns about $14.9 billion of the issue, has been lending it in large quantities to dealers. On Thursday, the size of the bid submissions to the bank dropped from previous sessions, and dealers were fully filled, New York Fed data show. Fails back to the central bank also declined, an indication that some short positions are being trimmed.

Treasuries suffered their biggest monthly loss in four years in February, as 10- and 30-year yields climbed to their highest levels in more than a year, pricing in an economic recovery as the U.S. virus infection rate eased amid the vaccine rollout. While next week’s 10-year auction may alleviate the current repo situation, the context of record-size auctions to finance pandemic relief, which Federal Reserve purchases have only partially offset, means that “investors are positioning appropriately for higher rates,” Bank of America strategist Meghan Swiber said in a note.

Adding to the crunch are yen-based investors. They have been liquidating older Treasury positions, according to traders in Asia, who asked not to be identified as they aren’t authorized to speak publicly. The impact in the repo market comes from how dealers absorbing the Japanese supply in old bonds -- those not used in benchmarks -- often sell current ones to hedge their positions.

Click here for Scott Skyrm’s comments on the rupture in repo markets

Treasury Short Sellers Face Rising Costs to Borrow 10-Year Notes

Supply Announcement

The first of two reopenings of the current 10-year note could ease some of the Treasury market ructions. The issue debuted in February at $41 billion, and the Treasury Department has indicated that both reopenings will be $38 billion, resulting in a $117 billion issue by mid-April. However, the Federal Reserve is likely to absorb about $2.4 billion of next week’s offering, according to Wrightson ICAP economist Lou Crandall, which would curb some of the supply coming to market.

“There are lots of specials in the Treasury market, so that will be alleviated,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc, referring to bonds that are in particularly high demand in the repo market. But “more Treasury supply certainly won’t make investors want to buy duration.”

The past week has seen tepid demand for sovereign debt offerings from Indonesia to Japan and Germany. With bond markets sitting on a “powder keg,” ING analysts see U.S. 10-year yields eventually soaring to 2%.

While Japanese investors, the largest foreign holders of U.S. government bonds, tend to be attracted to higher yields following any selloff, some don’t see demand roaring back.

The selling from Japanese funds is “likely to continue” as long as there is no warning from U.S. officials about the recent rapid pace of increase in yields, said Shinji Kunibe, head of global fixed-income group at Sumitomo Mitsui DS Asset.

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