Low Treasury Yields Don't Necessarily Signal Inflation Calm

The entire treasury curve has been flattening steadily since early April, especially the long end of the yield curve. The five-year U.S. Treasury yield peaked on April 5 at 2.33% and then began a steady decline starting April 11. The ten and thirty-year bond yields both topped on April 11 at 3.57% and 4.634%, respectively. Yields on all three instruments fell more than 40 basis points to their lows last week.

There have been a few explanations given for these significant interest rate moves. Many center on a reduction in perceived inflation risks. Interest rates at their most basic construct are supposed to include an embedded inflation premium. Therefore any decline in yields without a concurrent change in default expectations must mean that the credit market has lowered its inflation expectations.

This would seem to have been borne out by the action in commodity prices, particularly in the month of May. Many commodities, especially crude, saw their prices peak within this timeframe. The move in interest rates could have been predicting this.

Before closing the book on the interest rate/inflation story, it is important to examine the role exogenous variables have played. In the commodity space, the COMEX futures market has instituted a number of margin increases that have had the effect of reducing long exposure in several commodities. The most aggressive actions have come in crude and silver, but have been effected throughout the exchange's offerings.

So the reduction in prices across the commodity complex cannot simply be attributed to supply and demand expectations. Regardless of the reason for these margin changes, the decline in commodity prices, and by extension inflation pressures, may not be fundamental signals at this point.

With that in mind, we see something very similar happening in credit, specifically the market for U.S. Treasury securities.

The repo market (repurchase agreements) is rarely spoken of outside the inner workings of institutional finance. It is often complicated and technical, so it is largely left out of the public eye. But it was the center of the Panic of 2008 and is perhaps the most important source of marginal funding for financial institutions. At its peak the size of the market was estimated to be anywhere between $7 and $10 trillion.

In basic terms, a repurchase agreement is a collateralized loan. Banks hate to leave money idle, so if a particular bank has extra available cash to lend overnight it can do a repo transaction. Because the bank wants to accept as little risk with the loan as possible, the loan is collateralized with some kind of liquid security. For the most part government bonds (especially U.S. Treasuries) are the preferred collateral (during the housing bubble, AAA-rated mortgage bonds were heavily used, a significant cause of the panic).

Besides marginal funding, the repo market also provides another vital "service" to institutional investors. Firms that want to hedge interest rate or credit risk use the repo market to establish short positions on numerous credit securities, especially U.S. Treasuries. Because these hedgers want to remain in the most liquid part of the credit markets, they will use "on-the-run" treasuries as their preferred short. An "on-the-run" security is the bond issue that was most recently auctioned.

This establishes a key link between hedging in the credit markets and treasury auctions. In 2002 the Federal Reserve studied this phenomena and concluded:

"Dealers sell short on-the-run Treasuries in order to hedge the interest rate risk in other securities. Having sold short, the dealers must acquire the securities via reverse repurchase agreements and deliver them to the purchasers. Thus, an increase in hedging demand by dealers translates into an increase in the demand to acquire the on-the-run security (that is, specific collateral) in the repo market."

The treasury bond auctions in the past two months have been less than enthusiastically received. Paradoxically, these kind of weak auctions should have put upward pressure on interest rates, not the decisive decline we have seen. But if we think about the link between hedging and auctions, we might begin to think that weaker than usual auctions could be linked to a reduction in demand for hedging. In other words, the number of institutional short positions on U.S. Treasury bonds may be shrinking.

It is certainly possible that firms have reduced their hedging exposures based on these reduced perceptions of inflation. But there is also another exogenous explanation.

The FDIC changed its assessment regime on April 1, 2011, to include reserve balances banks carry with the Federal Reserve. The effect on repo rates was immediate, as reported by ZeroHedge. The general collateral (GC) rate fell to 6 basis points on April 5 (coinciding with the top in the five-year treasury). A week later, on April 11, the GC rate was all the way down to 1 basis point (coinciding with the top in the ten and thirty-year rates).

In addition to the GC rate, there is a second repo rate called the "special collateral" rate. A repo security is "on special" if it is in high enough demand in the market due to a large number of accumulated short positions. The special rate is below the GC rate, so if the GC rate falls to an extremely low level, like early April, it will push special rates into the negative.

Negative repo rates essentially mean that institutions are lending cash in the market and paying out interest, not receiving it. If that negative rate persists, the pressure on the shorts intensifies to the point where they have little choice but to exit their hedge by closing out that short position. If this were to happen throughout the repo market, it would be akin to a short squeeze.

This is exactly what has happened. The GC rate has hovered in the low single digits, and it is estimated that as much as a third of all special rates are and have been persistently negative (again, reported by ZeroHedge). The April-May move in treasury rates is nothing more than forced short covering.

The implications of all these exogenous moves are significant. In each and every case, some form of regulatory interference has been interjected into markets that were showing rising inflation risks. The recent retreat in commodity prices that seemed to be backed by falling interest rates is really nothing more than rising futures margins backed by a short squeeze in repo credit. In the end, all these moves say very little about the fundamental environment.