Fear pushes U.S. govt. debt interest rates negative


By Michael Mackenzie
Financial Times, London
Tuesday, November 24, 2009


Negative interest rates are back. Yields on short-term US government debt have fallen into negative territory as banks and investors park their cash in havens before the end of the year.

Strong demand for US Treasury bills, US government debt with durations of one year or less, suggests that dislocation and fear still pervade the financial system as institutions and investors show they are willing to forgo interest income completely or even take a small loss to own securities considered safe.

In the bond market, analysts say the heightened demand for short-term government debt also extends to the two-year note, reflecting a quest by banks and institutional investors for pristine year-end balance sheets, in what is commonly called window dressing on Wall Street.

William O'Donnell, strategist at RBS Securities, says: "One of the primary catalysts keeping yields at the front end low is the amount of liquidity in the system that needs to find a spot over the calendar flip."

Since late last week, yields on some Treasury bills maturing in January have traded and been quoted below zero per cent. Meanwhile, three-month bills have approached zero per cent, while the yield for six-month bills recently fell to a record low of 13 basis points.

On Tuesday, yields edged higher but remain near these lows.

This comes as the amount of outstanding Treasury bills has dropped by $209 billion to $1,859 billion since the end of August when one- and three-month bills were both yielding above 10 basis points and six-month paper was at 22 basis points.

Talk by some members of the Federal Reserve that the economy faces uncertain prospects next year has led many investors to conclude that official interest rates will remain on hold well into 2010. In some quarters, there are fears of a double-dip recession amid worries about commercial real estate and the potential exposure among small and regional US banks.

Andrew Lo, at the MIT Sloan School of Management, says: "Year-end is typically not a great time and the flight to safety into bills is motivated in part by general concerns about the economy and whether another shoe, such as commercial real estate, will drop."

Normally, the window dressing scramble starts in mid-December but this year a number of factors has sparked an earlier flight into Treasury bills.

This is the first year that all leading US banks, many sitting on big trading profits thanks to the rebound in risky assets since March, will close their books at the same time. In past years, investment banks such as Goldman Sachs and Morgan Stanley reported annual results in November and could thus add liquidity, by selling Treasury bills, during December as other banks and institutions rushed to window dress.

Another factor is the low level of overnight interest rates set by the Federal Reserve. Since last December, the federal funds rate has been placed in a range of zero to 0.25 per cent which, say traders, means that the traditional year-end demand for bills can draw rates into negative territory.

David Ader, strategist at CRT Capital, says: "Negative bill rates are one of the unintended consequences of having a low funds rate. It doesn't take much to push bills below zero when there is such a large demand."

Mr Ader also says that many holders of bills, such as central banks, are loath to lend them out into the market, and this has contributed to a squeeze, pressuring rates lower.

Treasury bills briefly traded negative ahead of the third quarter ending in September and a lack of liquidity has plagued trading at crucial times in recent years.

Ted Wieseman, economist at Morgan Stanley, says: "There has been a regular pattern during this crisis of bills being badly squeezed around quarter ends, but it's happening a lot earlier than normal this time around. Even last year when the financial crisis was near its peak we didn't see the pressures intensifying so far ahead of the actual calendar turn."

Last December, one-month Treasury bills traded as low as minus 9 basis points, and traders are not ruling out a similar move as the calendar enters December and liquidity becomes scarcer.

Some say that other short-term market rates could also approach zero and possibly turn negative.

Gerald Lucas, senior investment adviser at Deutsche Bank, says: "Overnight rates in the money market may well be negative at year end as banks, looking to reduce the assets on their balance sheet, will be reluctant to take overnight funds from investors."

Already, financing rates for Treasury collateral in the repurchase market are tight for the year end.

Joseph Abate, strategist at Barclays Capital, says: "Treasury collateral is trading around 3bp for the turn, which would be comparable with the June and September quarter ends."

Mr Wieseman says: "Our financing desk thinks it is likely on New Year's Eve that we will see a repeat of the previously unprecedented negative overnight rates first seen at the end of September."

But once the new year gets under way, the general view is just like that of last January; yields will rebound back into positive territory.

Mr Ader says: "We expect to see an ongoing bid and negative rates will be commonplace into 2010, righting quickly in January. While counterintuitive, negative rates simply reflect balance sheet window dressing demand and the premium for having very short-term liquid assets."

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