Negative Repo Rates

June 3rd, 2009 8:28 am | by John Jansen |

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!!)

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  1. 22 Responses to “Negative Repo Rates”

  2. By MFL on Jun 3, 2009 | Reply

    Thanks for this. Here is an interesting discussion of negative repo from the NY Federal Reserve from 2004; a nice discussion.

  3. By Fullcarry on Jun 3, 2009 | Reply

    Rough estimate: if you are short 1 Million face value 10yr notes instead of making 15bps on the money you lent you lose 300bps. The 315bps slippage on your money equates to about $88 a day. So instead of making about $4 of interest income on the 1M you lent it is costing you $88. Ouch!

  4. By troy on Jun 3, 2009 | Reply

    AKA convoluted bespoke uptick rule for Uncle Sam.

  5. By Gary on Jun 3, 2009 | Reply

    The 2/10 spread is telling us that the market wants the Fed to tighten — and by ‘the market’ I mean the real creditors of the United States, not the insolvent banks that are “investing” with printed money from the Fed.

    Based on fundamentals, the Fed should be tightning now. Of course, the Fed is no longer independent– it is now effectively a branch of the Treasury, which is a political department run by political appointees. The Fed is also being run by a man who was a full time academic who thinks increasing tuition by three times the rate of inflation for 30 years is perfectly reasonable– the man has never been in the real world or exposed to real competitive markets.

    The Fed **should** be tightening based on economics, but Bernanke is clearly no Paul Volcker. He won’t tighten until long after it is too late.

    Back in the early 1990s, the Bank of England operated under a similar dilusion that the pound could be legislated to a higher price than economics warranted. As a result, George Soros became a household name and the British economy suffered horribly.

    I don’t know who will play the part of Soros this time around. But I am very sure the U.S. economy will suffer.

  6. By John Jansen on Jun 3, 2009 | Reply

    Based on fundamentals, the Fed should be tightning now.

    With the unemployment rate racing to double digits and GDP still negative and a recovery when it arrives quite tentative, I am wondering,my friend,which fundamentals augur for tightening.

    I do not doubt that the massive liquidity provision and expansion of Fed balance sheet has the potential to be inflationary but that sure aint the problem which policy makers confront.

    Your prescription would turn a brush fire into a raging forest fire.

  7. By Gary on Jun 3, 2009 | Reply


    The Fed has a dual mandate — something you and Bernanke have forgotten.

    The Fed’s original mandate was only to guard against inflation (which is funny since they cause it). Congress added the “consistent with full employment and economic growth” part later.

    The economy needs to restructure — shift resources out of finance and into real production. There is no interest rate that can make that happen, higher or lower. One might even argue that excessively low interest rates are prolonging the eventual shift (at a price).

    Thus, your unemployment / GDP arguments are irrelevent. There is nothing the Fed can do to fix these. It can only create the illusion of growth by creating inflation — which is supposedly a violation of the Fed’s mandates.

    Market participants have become so dependent on massive debt and bogus accounting that they can no longer imagine the economy any other way. Pretending that government mandated jobs and inflation induced “growth” are somehow real? Come on

    The Fed cannot create real jobs or real growth via inflation. Greenspan tried that in 2001, and the experiment was a disaster.

    Paul Volcker had the courage to raise rates even though it made him hugely unpopular at the time — and we enjoyed 20 years of growth as a result.

    Greenspan lacked the courage (and the economic understanding) and we are now seeing the results of his easy money policies.

    The Fed should be raising rates — but the U.S. lacks leadership in Washington and on Wall Street.

  8. By Andrew on Jun 3, 2009 | Reply

    The Fed shouldn’t exist period, it is agaisnt the constitution. But thats another point!

  9. By Chicken on Jun 3, 2009 | Reply

    JJ – I agree, not anticipating tightening either, far from it. With today’s “worse than expected” spark, following yesterdays capital raise-ups(ahem), the arsonists have the perfect pinata.


  10. By John Jansen on Jun 3, 2009 | Reply

    Paul Volcker raised rates because the inflation rate was something like 18 percent.

    There is no inflation at the moment and if the question is do I want to trade a depression now for a Guarantee of no inflation later,then I think the proper prescription is to take the chance of inflation later and address the calamity of depression.

    I think that if you are making the point that the reserve managers wont withdraw the liquidity or that the Administration would not allow them to I think that is a separate argument.

    We were staring at the abyss and I think the Federal Reserve pulled us back from the edge of the cliff.

    Much of what they did can be critiqued and I am sure it will be for many years. But if you think of the enormity of human pressure those policy makers were under from last March through November when there was virtually a new crisis each weekend I think that history will accord them a good grade.

    I do hope they have the fortitude and strength too fight inflation when it reappears or when circumstances are such that a new round of it might be spawned.

    i run on

  11. By Gary on Jun 3, 2009 | Reply

    JJ: We were staring at the abyss and I think the Federal Reserve pulled us back from the edge of the cliff.

    It was the Federal Reserve’s easy money policies that put us at the edge of the cliff in the first place.

    We cannot solve excessively easy money problems with more excessively easy money

    Bernanke’s policies are the sort historically associated with a banana republic style economy.

    We have already had almost two years of Fed easing, and almost 9 months of quantitative easing — even if the alphabet soup of special lending programs weren’t officially labeled QE.

    After Countrywide and IndyMac went, the Fed did some questionably legal actions to make sure that Bear Stearns would be the last major failure. Then they intervened with FNMA/FHLMC. Then Lehman was the line in the sand. Or was it Wachovia? No wait, Merril was the Maginot line?

    Well, USB in Florida kicked it last week. The FDIC isn’t sure it can withstand expected failures without additional funding from Congress

    And this September, the first big wave of Option ARM resets kick in. Wells Fargo, already exposed to the California dream, is now the proud owner of Great Western Financial — the biggest option arm issuer, with heavy California concentration to boot.

    Bernanke’s plans to “renegotiate” mortgages is going absolutely nowhere– even the Fed is admitting this now. In order for the mortgages to be “renogiated”, the banks have to admit they are in default. The banks are having an impossible time raising new equity to pay for the losses they already have.

    There is no Fed Funds rate that will fix this. No amount of quantitative easing will change the outcome. The Fed cannot make worthless debt into something valuable, no matter what. No level of unemployment or GDP is going to give the Fed magic abilities.

    The one, and only, thing the Fed can do is make a bad situation worse by adding inflation to the mix. Now, in addition to underwater homeowners and unemployed people — we have elderly baby boomers on fixed incomes that aren’t keeping pace with honest assessments of inflation

    John, you whined earlier this year that you needed income from this blog… You are in denial — you are a victim of Bernanke’s “successful” policies. As is every member of AARP

    China and OPEC are being very vocal that they don’t want any more of Bernanke/Geithner’s “help”. Let the foolish AARP members get 100% of the government’s “help”, they say.

    The Fed can raise rates now, however unpopular that will be.

    Or you can have the illusion of growth next year and a miserable retirement for the next few decades.

    I agree that recent history suggests America will opt for the short term solution, and suffer in the long term.

    That most people are short sighted and will vote that way does not make it the smart choice

  12. By Gary on Jun 3, 2009 | Reply

    BTW — wasn’t “Chicken” all upset yesterday that this blog is filled with bond newbies? Chicken is so much smarter than the rest of us, and there are so many other blogs that are better… why is he back?

  13. By Gary on Jun 3, 2009 | Reply

    And last comment before I head off to lunch John…

    If you are reading Bernanke’s speech, even he is warning of the damage of perpetual budget deficits.

    In short, even if QE was a good idea (and it is not) — the country doesn’t have the money to do it.

    Almost two decades of QE in Japan have produced exactly the same results as they are producing here: nothing. No GDP growth. No reduction in unemployment. Mrs Wantanabe is now a regular CNBC guest, investing her nest egg in other countries with more forward looking economic planners.

    The Fed should be raising rates back to “neutral”, and let the economy make the adjustments it needs to make anyways. Inflation will only add to those problems

  14. By Chicken on Jun 3, 2009 | Reply

    I have nothing against newbies, as long as they admit they are instead of pretending otherwise. I thought I’d detected disrespect for others, which is the second thing I abhor. I don’t post here much and don’t intend on making it a habit, but I thought I saw something in JJ that I admired (including but not least his CV Ballot interests) so I thought I’d throw out some ideas.

    I don’t know everything, and won’t ever pretend otherwise.

    Remember, there are no stupid questions, none. None of us knows everything there is to know, the experienced and seasoned have lots to offer so let’s pay them some respect. They’ve earned it in their own right, and we should be greatful if/when they’re willing to share.

    Gary – Your economic thesis is too simplistic IMO, try not to think in the past, but into the future and anticipate what must be done to save the federal reserve system from total collapse. This is, and will be, the current path from my perspective.

  15. By Chicken on Jun 3, 2009 | Reply

    Gary – “The Fed should be raising rates back to “neutral”, and let the economy make the adjustments it needs to make anyways. Inflation will only add to those problems”

    You have a good point here, but now is not the time. Rest assured, the Fed will eventually normalize rates, but only after normalizing the currency. (my opinion)

  16. By Gary on Jun 3, 2009 | Reply

    Chicken: “…but now is not the time.”

    Look man… I got the shakes really bad. Your right. Your right I got a problem and I need help. I am addict. Your right. But look at me man! I’m shaking and I am sweating and I can barely talk! I need a fix right now man. Just give me a little something now…. take the edge off. I promise I will go to rehab next week.

    A real friend would say the US is in denial and needs to get help now. The drug dealer will give you another hit.

    Friend / pusher: Guess which one Bernanke is?

  17. By Bman on Jun 3, 2009 | Reply

    Chicken, you were exposed yesterday. Just move on.

  18. By Chicken on Jun 3, 2009 | Reply

    Exposed? How rude. Good bye and good riddance.

  19. By Andrew on Jun 3, 2009 | Reply

    somebody has too much faith in the Fed! chicken! As I said the FED shouldn’t exist. Gary is right, when we go to raise rates it will put the economy back into another recession which will cause us to drop rates again to spur growth, and this will continue to happen over and over again. Thats the best hope for our economy. Japan is in what I call a modern day depression.

  20. By Chicken on Jun 3, 2009 | Reply

    Andrew – Refer to my earlier post referencing arsonists, that should help clear up where I’m coming from.

    At least you weren’t rude, so I felt a slight obligation.

  21. By hooligan on Jun 21, 2009 | Reply

    hooray for Gary! why aren’t you in Government? I will tell you why, because we are not dealing in reality. I have alot of sympathy with the view that the Fed and the Unions were required to effect better money transmission and correct corrupt business management. I am of the view that we are now in the phase where money is no longer a store of real value and is a means for those in the know to turn billions of tax payer dollars into their own profits. The lunatics/fraudsters/intellectually corrupt have taken over the asylum/laundered money owners/coffee table cloud 9’ers. Money is no longer a store of wealth and for the second point, there is no equivalent of a union to protect anyone from corrupt bosses. Here the definition of corruption needs to be redefined. Corruption now is the taking of money in exchange for no value, knowing that someone will be worse off for losing that value. Well I used to think that times change and values don’t. I agree that the non-retail banking arms should be hived off with no help, leaving the payments system intact and the risk taking waiting like an investment banker rising from the crapper. There are talented risk takers out there..but we need to connect profit earned from trading financial assets into real assets (like property and goods) in another way. Maybe create a sandpit in the bahamas and catch the losers in a welfare net later.

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  2. Jun 3, 2009: Notable re 10 year Treasury « Wasatch Economics
  3. Jun 20, 2009: Treasuries Still At Negative Repo Rates | Bear Market Investments

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