Deja Vu: Treasury Shorts Meet Treasury Shortages

Investors like to short bonds even Treasuries as much as they might stocks and their ilk. It should be no surprise that profit-maximizing speculators will seek the best risk-adjusted returns wherever and whenever they might perceive them. If one, or a whole bunch, has to first “borrow” a security the one doesn’t own in order to sell something at a high price betting the price to go down, you can likewise bet there’s someone out there in the financial landscape more than willing to let you borrow that security – for a fee.

Leverage all around.

When it comes to the intersection of bonds and securities lending, money dealers may not have quite the inventory themselves but they certainly have access to any kind of instrument you could want to borrow from those who do (insurance companies and pension funds, to start with). If, as a speculator, you think inflation’s going up and growth prospects system-wide are improving, then your shorting sense is surely to zero in on safe and liquid assets especially if they are yielding somewhere down close to zero.

Asymmetry is the name of the game here; a minor burst of inflation following a time when deflationary pressures (not the Fed; we’ll get to what the central bank actually does in a minute) had overwhelmingly pushed government bond prices sky high would appear to offer fat, low risk-adjusted returns (because a little inflation is, many say, all but guaranteed and there’s a chance, they also say, a lot more could follow). All anyone needs to do is borrow some Treasuries and sell what they don’t actually own.

This kind of thing, however, isn’t exactly a specialist idea. Right around the time you’re thinking short long UST’s pretty much everyone else is thinking the exact same thing; chasing the identical White Whale identified by every single internet financial news story parroting whichever Fed Chairman’s boasting about what their bank reserves will certainly do to the price environment.

While the securities lending side of the financial world can be and most often is pliable, fungible, and, at times, horrifically forgiving, there can be a situation such that there are “too many” shorts. Securities dealers – or the insurance companies they borrow securities from – can become skittish themselves without notice; the dealer who let you borrow a UST yesterday at a premium you liked then today decides to up the fee and reduce your leverage (changing the risk-adjustment to your expected profit calculation).

That’s when it comes time to cover. How? Buy the thing back? Ha!

Why not borrow it from someone else?

This kind of tangled mess of heaving demand for already-borrowed securities can manifest in something called “specialness.” In repo markets, this is indicated when the repo rate for a specific security sticks out like a sore thumb – because it plummets below the general collateral rate or specific rate of specific securities in the maturity range around the one in question.

This particular instrument is now “special.”

What that means is cash lenders are willing to accept less return in order to lend cash at the same time they are borrowing this targeted special security; all that means is they aren’t really lending cash at all, both cash and collateral here in repo means something a little different than a securitized interbank loan.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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