Inverted Repo

The repo market has been trading with negative rates recently. Financial institutions are demanding treasuries to short as speculative bets on rising rates. The demand for this variety of repo collateral may have become high enough that they are now willing to pay negative repo rates for them. So in-effect, this instantiates an inverted repo market where rather than supplying the demand for cash via loans collateralized by securities, this market is supplying the now-greater demand for treasury securities with loans backed by the now-less sought-after cash. The repo market is the biggest source from which to borrow treasuries on speculative (few months) timeframes. This upends the very purpose for which the repo market was established (inter-bank liquidity), but such are the times.

Out of the $120 Bn/month of its current QE, $80 Bn consists of the fed buying treasuries from the commercial banks in its (ultimately futile) campaign to maintain suppressed rates. This is serving to further drain the supply of treasuries from the very repo market which has been signaling that it now needs a greater supply of them, replacing it by bank reserve cash that the market says there is already an excess of. In addition, Ms. Yellen said that she will spend $1.1 Trillion directly out of the Treasury General Account, rather than auctioning new treasuries, to pay for the COVID relief stimulus and the Green New Deal, etc. This further deprives the market of this treasury ‘collateral’ that it needs now to continue operating properly.

If the senate gridlocks over further new stimulus spending, issuance of new treasuries will dropoff, further exacerbating this ‘collateral’-cash imbalance in the repo market. If the result of these actions is a demand for treasuries sufficient to drive their price up, all the banks and other financial institutions with open shorts on them could conceivably get caught in a short squeeze that would make the Gamestop event look quite trivial. At that point, the repo market would not have the collateral it needs and could reach for less-integrous assets (e.g., various ABS’, rehypothecated treasuries), which would make this market, and the world’s banking system, far less reliable and stable. If this lower-quality collateral were found unacceptable to counter parties in the repo market, a shortage of dollars in the global financial markets could arise sharply.

There is no way to predict whether such events will or will not occur, but they now are possibilities that did not exist previously. The coming tax on capital gains is one major factor changing the incentives and strategies for investors now.

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