On September 26, when we wrote "As US Default Risk Spikes To 5-Month High, Here Is How To Trade The Debt Ceiling Showdown", we suggested a simple 1M/1Y Bill flattener, which has since resulted in a massive profit to those who put on the trade with appropriate leverage, leading to the steepest outright inversion the short-end curve has seen on record. For those who engaged in this trade, it may be time to book profits and move on, as the risk of a negative catalyst - a shutdown/debt ceiling resolution - gets higher with every passing day that we move closer to the October 17 X-Date. However, those who wish to remain engaged in the short end of the bond market where the highest convexity to the daily newsflow can be found, one possible alternative trade is to shift away from cash markets, and into shadow banking, via the repo pathway.
It is here that Barclays' Joseph Abate sees a substantial arbitrage opportunity, as "repo investors begin to focus on the underlying collateral" and "start to make a distinction between debt that is most subject to payment delay and paper that is not." The result would be that as cash leaves the funding market, "the financing rate on all Treasury collateral – regardless of its maturity cycle – will rise." Indeed, during the last debt crisis in the summer of 2011, Overnight repo soared from 1 bps to 28 bps in the span of a few weeks. It is this trade that may once again generate substantial alpha for those who wish to bet on continued Congressional dysfunction because the October US Treasury repo future is currently trading at an implied yield of just over 11bp, having cheapened by more than 3bp since September 23. "Depending on how quickly the debt ceiling is raised, we expect this implied yield could move higher ahead of October 17" Barclays concludes.
Full note for those who are brave enough to fight if not the Fed, then certainly the specter of a congressional compromise:
1m bills have cheapened from barely 0bp (there were some negative rate trades a week ago) to 14bp on Friday morning. This sharp cheapening reflects the fact that while investors believe the US Treasury will not default and the risk of a delayed payment is extremely low, they are unwilling to take any chances. As a result, the 4wk bill is now trading about 4bp higher than the year bill and about 10bp above the 3m bill. Judging from the behavior of this market in July 2011 when the debt ceiling negotiations were last this intense, 4w bill yields probably have some more room to rise. Assuming the debt ceiling is not increased this weekend, we expect the 4w bill could reach 17-20bp by early next week.
Primary dealers also appear to be taking no chances. In the week ending September 25, they reduced their bill inventories by more than 50% to just $20bn. We expect next week’s release will reveal a similarly sharp decline in bill holdings.
Repo investors are also extremely risk averse. Our sense is that some investors, seeking to avoid the risk of payment delays on underlying collateral, may move away from the repo market entirely. As cash leaves the funding market, the financing rate on all Treasury collateral – regardless of its maturity cycle – will rise. Overnight Treasury repo was trading around 1bp in July 2011, but as the critical August 2, 2011 deadline approached, collateral rates began moving higher – rising to 28bp on August 1. The October US Treasury repo future is currently trading at an implied yield of just over 11bp, having cheapened by more than 3bp since September 23. Depending on how quickly the debt ceiling is raised, we expect this implied yield could move higher ahead of October 17.
As repo investors begin to focus on the underlying collateral, we expect they will start to make a distinction between debt that is most subject to payment delay and paper that is not. The Treasury coupons most sensitive to a payment delay or a maturity extension are those with a payment due on the late October/April cycle. There are 23 coupon CUSIPs in this series – totalling $773bn. Of these securities, $135bn are held by the Federal Reserve in its System Open Market account. At the end of August, money market funds held just over $6bn worth of April 30, 2014 debt. They held another $24bn worth of bills (or short coupons) maturing on October 31, 2013.
Finally, as the debt ceiling negotiations continue, we expect some money to start flowing out of government-only money funds. Like other investors in the front end, these investors – although they attach a small probability of a Treasury payment delay – are unwilling to risk a “buck-breaking” event in their funds. In the run-up to the August 2011 debt ceiling increase, government-only money fund balances declined by 10% – in roughly a week. So far, however, these money fund balances have been very stable with few signs of a pick-up in redemptions.
It goes without saying that once the debt ceiling is increased, all such distortions will quickly reverse.
Of course, if the Treasury does go through the X-Date with no deal in store and ultimately succumbs to a technical default, the question of who owns what paper securities and has paper P&L, will become irrelevant, as all attention will very quickly shift solely and exclusively to physical assets.