Five-Year Treasuries 'Special' As Safety Demand (or European Risk Aversion) Causes Collateral Shortage

Andrew Brodsky of Stone & McCarthy notes that fed funds and repo rates declined from mid June through mid July amid increased excess reserves in the banking system and reduced collateral. Fears of exposure to European peripheral debt pushed money market funds into the repo market as they turned away from lending to euro-zone banks. In late July and early August, repo rates rose modestly from record low levels. The GC rate jumped to 42 basis points as investors began to pull out of the market and move into cash. Over the past few weeks, short-term rates eased in response to the resolution of the debt-ceiling debacle. The continued concerns over the global economy, European sovereign debt, and Bank of New York Mellon's decision to start charging fees on large cash deposits have spurred a demand for short-term Treasuries and repo. The increased demand for securities amid a shortage of collateral will continue to pressure rates.

This morning, the on-the-run 5-year issue continues to trade special. The issue is trading at -30 basis points after opening at -20 basis points. This could be supportive for Wednesday's $35.0 billion auction. All other issues are trading between 15 and 20 basis points, a bit higher compared to recent weeks, but basically in line with the General Collateral rate. The GC rate is trading at 20 basis points this morning, the highest rate since early August. The Fed funds rate has opened at 10 basis points since last Wednesday leaving the effective funds rate at 8 basis points through Friday.

The chart below depicts the General Collateral (GC) rate and the Fed Funds rate. After rising in late June and early August, both rates have drifted lower, until recently.

Chart: Bloomberg

With money market funds waving fees and unable to find any yield, we wonder how long before the NAV variation bands are widened and they become 'risky discount bonds' in all but name.


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