Here we go again: turbulence drags the rest market

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Usually, these trades happen in the background, with little fanfare. But from time to time, the system breaks down, as it did in late 2019 and again a year ago. This is another one of those moments.

The rate for borrowing ten-year cash in the replacement market fell to -4% this week, which is very rare. This means that investors are basically paying to borrow ten-year bonds, when it is usually the other way around.

Crowded short bets

With Wall Street economists sharply raising their GDP estimates, investors have begun to bet en masse for Treasury rates to rise sharply. One way to express this view is to make short treasures. (When Treasury prices fall, their rates go up.) To carry out this trade, hedge funds borrow from the Treasury in the replacement market, sell them, and agree to buy them again, ideally at a lower price. to be able to pocket the difference.
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But these bets are creating intense demand in the ten-year cash replenishment market that can be reduced.

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

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

“Mouse and cat game”

Wall Street is essentially testing the Fed, pushing to see how far the central bank will raise rates before intervening.

“It’s a cat-and-mouse game,” said Mark Cabana, head of rate strategy at Bank of America. “The market is challenging the Fed. The Fed is being a little bit clever and basically telling the market, ‘Go fix it.’

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

If rates were to rise sharply, it would increase the cost of everything from mortgages and car loans to junk bonds.

And U.S. stocks fell last week as Treasury rates rose. The same thing happened on Thursday, when investors were scared that the ten-year Treasury yield rose well above 1.5% in comments from Fed chief Jerome Powell. Higher yields on ultra-safe public bonds would rob the thunder of riskier assets like stocks.

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

The overheating debate

However, higher rates would also indicate that the U.S. economy is finally back to normal after more than a decade of slow growth and anemic inflation.

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

Dudley said 1.6% of Treasury rates are “nothing” and that projected yields will eventually rise to 3% and 4%, or even higher.

“The bond market right now is a little unrealistic about their expectations for the Fed. They certainly want the Fed to stop that,” said Dudley, who was previously a top-tier economist at Goldman Sachs. “And I think the Fed’s view is no. We’re not going to stop it. That’s normal. That’s what happens when the economy looks like it’s really going to recover.”

Cabana said Dudley, whom he regards for his time working 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 stimulating growth and achieving full employment is too high U.S. interest rates,” Cabana said. “That would tilt the apple cart.”

The problem of the California Fed Hotel

When the replenishment market exploded in the fall of 2019, the New York Fed rescued the company by promising to inject billions of dollars into the markets. The so-called night replacement operations successfully calmed the markets, until they erupted again during the pandemic shock last spring.

The Fed would probably want to take a practical approach this time around as it tries to slowly withdraw from crisis mode.

However, Cabana does not believe 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 must continue to issue treasuries, and the Fed has been the biggest buyer of these bonds. The Fed buys about $ 80 billion each month through its quantitative easing (QE) program.
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“The Fed will have to increase its footprint in the markets. That’s how it ends,” Cabana said.

One possibility is that the Fed could further increase its already huge QE program. Another option is to reactivate Operation Twist, a post-2008 crisis tool designed to suppress long-term rates.

All of this highlights the Fed’s difficulty in developing its emergency policies.

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

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