With Special Repo Negative Again, Is General Collateral The Next "Buck-Breaking" Source Of Frozen Liquidity?

Tyler Durden's picture

Back in April, Zero Hedge first exposed the impact on the repo market as a direct consequence of the then introduced FDIC assessment rate, which pushed general collateral rates to just above zero, and in some cases, outright negative. Since then GC repo rates have meandered well lower than the historical average, somewhere in line with the IOER, and the ongoing 20 bps arb available to banks who have the wherewithal to arbitrage the GC-IOER spread, indicates that not all is as it should be with the repo market. This was to be expected once the FDIC started messing around directly in the multi-trillion repo market. Well, courtesy of increasing tightness in European liquidity where contagion concerns have spooked money market participants, forcing them to enter the already thin GC market, rates have once again collapsed, and as Barclays' Joseph Abate points out, "Treasury collateral fell from around 6bp earlier this month to barely 1bp this morning. This means that every special issue – even those with only a modest premium in the repo market – trades at a negative rate." As a result, the GC and the special repo rate, together with participation in the ECB's MRO operation (update tomorrow) and Chinese SHIBOR, have now become the best indicators of what is truly happening in the liquidity underbelly of the multi-trillion unsecured market. Alas, this latest move has unpleasant implications for money market managers, who unable to find yield in repo (0.01%?) will now be forced to look for higher yielding assets, and thus expose them to even more contagion risk once the house of cards falls, facilitating the "breakage of the buck" once again just like what happened in the aftermath of the Lehman catastrophe, and snarling all global fund flows, forcing the Fed to become liquidity provider of last resort. But no need to worry about this: after all Bernanke's centrally planned economy would never let this happen.

More from Barclay's Abate:

Repo typically richens at quarter-end as dealers shrink their balance sheets ahead of quarterly reporting. We expect this normal richening to be amplified as the regular quarter end seasonal redemptions will likely be over-interpreted in the media as a sign of investor flight. However, like the mid-June corporate tax date, most of these redemptions will have nothing to do with investor concerns about money fund exposure to European banks. Nevertheless (and despite very high levels of seven-day liquidity), we expect money funds managers to be even more cautious than normal, ramping up their repo holdings while letting bank paper run off as much as possible. As a consequence, repo rates should linger under 5bp through mid-July.

The next part is what the FDIC and Bernanke should read when analyzing "systemic risk contagion 101":

The longer repo rates stay under 5bp, the more likely money funds are to reallocate toward higher-yielding assets. Some of the money parked temporarily in repo is likely to leak out into time deposits and non-European bank paper. We expect rates on this paper to fall as repo creeps higher – especially as some of the initial anxiety fades.

Of course all that is needed is for the only safe paper available to see an influx of safe money chasers, while other liquidity conduits to see departures en masse for true unintended consequences to rear their ugly head. So far the artifcially wide IOER-GC spread has not been much of a factor on overall liquidity. But now, with just 4 days left in QE2, things may change.

In theory, by steadily removing collateral from the repo market, the Fed’s daily purchases should consistently cause repo rates to fall. However, we find no evidence of any daily richening in overnight repo rates. Instead, it appears that the Fed’s daily purchases of roughly $8bn are too small to have much of an effect on the multi-trillion dollar repo market.

This will simply further push the cycle away from equilibrium.

Which begs the question: whereas as back in September 2008 money market were the culprit for the near apocalyptic liquidity freeze, will the culprit this time be the general collateral market, where everyone is now parked, and where a sudden and dramatic shift away from exorbitantly rich rates would likely have the same impact as the realization that everyone in Money Markets was swimming naked.

We don't know the answer. Unfortunately, we are 100% certain that neither do the Fed chairman.

Below is a chart of General Collateral in the past 6 months. Repoer beware.