A rush to short US Treasury bonds after Federal Reserve chairman Ben Bernanke raised the prospect of QE tapering this May saw arbitrage managers in Asia hit with rising hedging costs, eating into returns.
The Fed’s plan to pare its quantitative easing (QE) programme – hinted at in May, announced in June and potentially starting next month – sparked an uptick in fixed income managers shorting 10-year US Treasuries in anticipation of a change in the interest rate cycle.
Some repurchase agreement (repo) traders reported to AsianInvestor that relative-value managers – which simultaneously go long and short two related securities to profit from discrepancies – had to act quickly to short their Treasury positions.
To cover themselves, the managers went to the US offshore repo market to borrow Treasuries across three-, five-, seven- and 10-year durations.
But the 10-year US treasury repo rate dropped sharply at the end of May, falling from -0.10% on May 22 – the day of Bernanke’s tapering comment – to -0.75% on May 30. The lower the repo rate, the more expensive it is to borrow a bond in the repo market.
Demand to borrow benchmark Treasuries in the repo market became so extreme that for a period in June the repo rates on these trades fell into negative territory below the 0-0.25 Fed funds target rate.
In other words, borrowers effectively tie themselves in to the end of the tenor to receive below the value of holding cash at market interest rates. The fact that demand remained so high demonstrated how desperate borrowers had become.
“We saw dealers proactively looking to source US Treasury 10-year notes from the Asian client base when the repo cost in the US interbank market dramatically increased,” notes Percy Sewell, Asia-Pacific head of repo/collateral trading at UBS.
Similarly, Edward Gildar, managing director of Asia fixed income at Citi, noted an increase in investor interest in borrowing various benchmark US Treasuries in the repo market.
However, he stressed that sporadic shortages of specific securities happens occasionally, triggering higher borrowing costs, but generally does not persist.
By press time, the 10-year repo rate was bidding at -0.20%, down from -0.02% on August 21 which was considered a normal level. Nevertheless, some traders note that the spike in repo costs hit fixed income arbitrage managers hardest, and that this will likely be reflected in their returns.
While the repo markets in the US and Europe represent 60-70% of their respective GDPs, the repo market in Asia including Japan is still small, accounting for just 8% of GDP. Excluding Japan, it is 1.7%, according to data from the Hong Kong Monetary Authority.
More generally, dealers report that post the 2008/09 financial crisis there has been increasing interest among banks and corporate institutions to use the repo market for more of their financing requirements, moving away from the traditional unsecured interbank lending market.