The rate to borrow 10-year Treasuries in the repo market plunged to minus-4% this week, a very rare occurrence. That means investors are essentially paying to borrow 10-year bonds, when normally it’s the other way around.
Crowded short bets
But these bets are creating intense demand in the repo market for 10-year Treasuries that can be shorted.
“This turmoil is being caused by the bond market swinging around as people realign their views on the economy,” said Scott Skyrm, executive vice president in fixed income and repo at Curvature Securities.
The 10-year Treasury rate spiked to 1.6% last week, well above the low last March of around 0.3%.
‘Game of cat-and-mouse’
Wall Street is essentially testing the Fed, pushing to see how high the central bank will allow rates to rise before stepping in.
“It’s a game of cat-and-mouse,” said Mark Cabana, head of rates strategy at Bank of America. “The market is challenging the Fed. The Fed is being a little coy and basically telling the market, ‘Go sort it out.'”
But the Fed doesn’t want to harm the recovery or spook Wall Street.
If rates rise sharply, it would raise the cost of everything from mortgages and car loans to junk bonds.
“It will reach a tipping point where it has negative financial market consequences,” Cabana said.
The overheating debate
Yet higher rates would also signal that the US economy is finally getting back to normal after more than a decade of slow growth and anemic inflation.
Dudley said 1.6% Treasury rates are “nothing” and predicted yields will eventually climb to between 3% and 4% — or even higher.
“The bond market right now is a little bit unrealistic about their expectations for the Fed. They certainly want the Fed to stop this,” said Dudley, who was previously a top economist at Goldman Sachs. “And I think the Fed’s view is, no. We’re not going to stop this. This is normal. This is what happens when the economy looks like it’s going to actually recover.”
Cabana said Dudley, whom he respects from their time working together at the NY Fed, may be taking too much of an academic approach.
“The greatest risk to everything the Fed is trying to achieve in terms of stimulating growth and reaching full employment is too high US interest rates,” Cabana said. “That would tip the apple cart.”
The Fed’s Hotel California problem
The Fed would probably like to take a hands-off approach this time as it seeks to slowly retreat from crisis mode.
However, Cabana doesn’t think that will happen, in part because of the enormous federal budget deficits created by the pandemic and efforts to revive the economy.
“The Fed will have to increase its footprint in markets. That’s how this ends,” Cabana said.
All of this underscores how difficult it is for the Fed to unwind its emergency policies.
“It’s the Fed’s Hotel California problem,” Cabana said. “You can check out, but you can never leave.”
Read More: Here we go again: Turmoil rocks the repo market