I was just reading the excellent morning note produced by David Ader of RBS Securities and he pointed out something which I have failed to mention here and for that I apologize.
The 10 year note is trading at NEGATIVE 3 percent in repo. What does that mean?
When one shorts a bond he needs to make delivery of the security and the security must be borrowed from someone. Typically, when one borrows a bond he (or she) is giving money to someone and earning interest on those funds. For a bond on which there is special demand the interest earned can be lower than prevailing short term rates. In effect, the owner of the bond receives a preferential financing rate because of strong demand for the bond in the “repo” market.
This is turning out to be longer than I thought but bear with me. When the funds rate was 3 percent or so the penalty to the lender of the funds would be that he might earn as much as 300 basis points less than the overnight financing rate if demand was such that the repo rate on the heavily demanded bond fell to zero. That was an onerous penalty and could make shorting an issue an expensive proposition.
However,the penalty became less onerous when the Fed reduced rates to nearly zero. If the overnight rate is 25 basis points and the repo rate is zero then the penalty in foregone interest is quite small. This would encourage shorting of issues and created massive delivery problems as deliveries could not be completed.
The Federal Reserve and the Treasury and dealers solved the problem by implementing NEGATIVE Repo rates on May 01 2009.
So to get back to my original example of the 10 year note. If one is short that bond today and needs to borrow it,one actually lends the money to the other dealer (who supplies the 10 year note) and rather than earning interest on the proceeds you pay the owner of the bond 3 percent for the right to rent that bond. So you lose 3 percent overnight on the transaction.
What does all this say about the bond market?
It means that there are massive shorts in the 10 year note. The shorts would come from two sources. When the mortgage convexity folks pay in the swap market, generally the dealer who has received from the MBS client is now long the market. That trader will hedge that transaction by selling Treasuries. Given the extent of the paying in mortgages that trade has been substantial.
The second source of shorts is the yield curve trade. The 2year/10 year spread has widened to record levels. Many traders are long 2year notes and short 10 year notes. I think that position is massive and has abetted the repo bid in the 10 year issue.
What can we do with all of this information? We can use it to be wary of sharp rallies in the 10 year note as when the student body decides to move left or right in unison on this one it should produce a significant improvement in the 10 year note.
I hope that makes sense.
I do not have a Bloomberg here but after the market settles in I will ask one of my contacts to run the numbers and I will demonstrate the real world cost of all of this. (Or benefit if you are the happy holder financing your 10 year notes at a negative rate!!)