Monday, March 24, 2008

Strain in Repo market signal the high demand for Treasury

Rate markets have been so consistently abnormal for so long," said William O'Donnell, rates strategist at UBS Securities in Stamford, Conn., it will take more than liquidity boosters to restore confidence and to put the economy back on track. Last week, rates to borrow Treasurys in the securities repurchase market -- essential to the smooth functioning of the financial system -- turned negative and Treasury bill yields plunged to levels not seen in more than 50 years, signaling strong demand for government debt. Bond prices rise when yields fall. Fails in the repo markets have also risen as it has become uneconomical for investors to return loaned Treasurys. At one point on Thursday, the three-month T-bill repo rate was quoted at -0.2%, and bills to December were seeing bids of -0.25%. These rates typically hover around the target fed-funds rate, which is at 2.25%. Fixed-income markets were closed Friday for the Easter holidays. Given the massive demand for Treasurys, and investors' tight grip on government debt once they've snatched it up, "the Fed adding to the supply mix should help," said Kevin Flanagan, fixed-income strategist at Morgan Stanley Individual Investor Group. At a minimum, the Fed's lending facility should nudge repo market rates higher this week and slow the frenzied buying of T-bills. The facility complements another effort by the Fed to get more liquidity to dealer banks -- the primary dealer credit facility. That allows securities firms to borrow at the discount window, a privilege normally accorded only to regulated financial institutions that take deposits. Also this week, the Fed will conduct March's second Term Auction Facility sale, which auctions funds to banks that take deposits. The auction Tuesday will be the Fed's eighth sale under the program, which was created late last year to address liquidity pressures after banks proved reluctant to tap into the discount window for emergency borrowings. The auction sizes have increased steadily, with the Fed this month offering $100 billion in two auctions. All this liquidity comes as quarter-end -- typically a volatile time for markets -- looms. Investors are normally unwilling to have riskier loans on their books this time of year and hoard the safest possible securities.

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