Repo squeeze threatens to spill over into funding markets

What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally.

After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.

The squeeze may be short-lived — with analysts pointing to a confluence of two factors for a sudden shortage of dollars — but it still highlights the vulnerability of a key borrowing market.

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What happened was an unfortunate coincidence — just as companies were withdrawing cash from money markets to pay corporate tax, a glut of new bonds appeared on the market as the U.S. government sold some $78 billion of 10- and 30-year debt last week.

With just $24 billion of bonds maturing in the period, this became one of three occasions this year when the imbalance between debt redemption and cash needed to buy new Treasuries exceeded $50 billion.

Suddenly there was a scarcity of dollars at the same time as a glut of Treasuries, which banks typically lend out to investors with spare cash through repurchase agreement. As a result, the overnight repo rate more than doubled to 4.75%, the highest level since December, according to ICAP pricing.

“Repo pressure is almost entirely a settlement story with $54 billion of net supply in Treasury coupons landing on already very crowded dealer balance sheets,” Blake Gwinn, head of front-end rates at NatWest Markets, wrote in a research note. The tax deadline probably exacerbated the situation, he wrote.

The increase in repo rates then pushed up the cost of holding Treasuries, leading the spread between two-year yields and interest-rate swaps to shrink on Monday.

It wasn’t long after that that dollar-funding stress started showing up elsewhere, with the three-month premiums to swap currencies such as euros or yen into dollars jumping. Short-dated eurodollar futures dropped, and implied rates rose, as short-term funding rates climbed.

The repo market remains vulnerable to short-term liquidity squeezes anyway due to structural issues, which often surface around year-end.

“The culprit is the scarcity of bank reserves, which are the only asset that provides banks with intraday liquidity,” Priya Misra, head of global rates strategy at TD Securities in New York, wrote in a note. “Reserves have been declining since 2014 and we expect them to decline further as Treasury’s cash balance increases and currency in circulation grows.”

Bloomberg News
Monetary policy
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