Money markets unusual repo notes demand leads to 7 year special

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NEW YORK, Feb 21 Strong demand in the overnight repurchase market for seven-year Treasury notes as collateral in short-term cash loans has driven rates into negative territory, and traders are not sure why. Participants in the repo market exchange cash in overnight loans for securities like Treasury notes. The condition, known as a "special," is the most dramatic seen in the seven-year maturity since the Treasury Department again began issuing seven-year notes in 2009, after a hiatus of more than 15 years. According to Roseanne Briggen, an analyst at IFR Markets, a unit of ThomsonReuters, the rate on seven-years as collateral is between -28 basis points and -35 basis points. That compares to a general collateral rate of between 9 basis points and 7 basis points for other types of securities that are not trading "special." The Federal Reserve's latest easing program, Operation Twist, is the most likely culprit, according to a repo trader at a large Wall Street bank and a money market analyst at another major bank, both of whom declined to be identified. Operation Twist is the Fed's latest attempt to force long-term interest rates lower and stimulate the economy by manipulating Treasury yields. The Fed is selling the short-term Treasuries it has on its books and using the proceeds to buy longer-dated Treasury notes and bonds - including seven-year notes. A few of those most recent purchases may be causing a scramble for seven-year notes by market participants. "We're just wondering if it's a function that the Fed bought too many last month," said the repo trader. As of Jan. 31, the Fed had purchased roughly $61.8 billion in Treasury notes with maturities of between six and eight years since Operation Twist began in October, according to a Barclays Capital analysis of data released by the Federal Reserve Bank of New York. That's roughly 51 percent of the gross issuance in six-to-eight-year maturities, according to Barclays. "The Fed purchased a large amount of the issue and took it out of the market, effectively," said the money-market strategist. The Fed continued buying seven-year notes in February. It would not be the first time a few huge Fed purchases took enough of a certain security out of the marketplace to leave traders scrambling. "It's like last spring when they bought on-the-run three-year notes at significant size, they removed enough of the float that the issue went special," the repo trader said. In the spring of 2011, the Fed was still engaged in its second quantitative easing program, during which the central bank expanded its balance sheet by buying Treasuries across the yield curve to help lower long-term rates. But the "special" in sevens - and a similar condition in five-year notes in the repo market - could also be driven by coming Treasury auctions on Wednesday and Thursday. The Treasury Department is set to sell $35 billion in five-year notes and $29 billion in seven-year notes. Often times, Treasury traders arrange to "short" current issues in maturities that are going to be auctioned soon, effectively setting up a bet that their prices are going to cheapen after the auction occurs and a new issue hits the market. There may be other factors, too. "One of the reasons why the five-year is particularly short, apparently it is a derivative-related short," Briggen said. "I don't know exactly what's entailed, but that's exacerbating the premium." Tom Simons, a money-market economist at Jefferies & Co. in New York, said it might also be reasonable to blame the shortened week following Monday's Presidents Day holiday for some of the strange conditions. "With repo being higher than it was previously since basically the middle of January and this week being kind of a thin week for desks, some dislocations that may not normally be there may be at work," he said. In Europe, extremely strong demand at a sale of six-month Spanish treasury bills on Tuesday suggested banks may take a sizeable amount of three-year funds from the European Central Bank next week. Demand at Tuesday's auction for the bills, which can be used as collateral at the longer-term tender, was more than 10 times the amount on offer, up from seven times a month ago . Spanish debt sales this year have been strongly supported by domestic banks, as have Italian auctions to a lesser degree, enabling the former to complete around a third of its 2012 borrowing target already. Shifts in demand at the ECB's one-week and one-month tenders last week also reinforced expectations of a large take-up. Banks cut their intake of one-month funds to 14 billion euros from 39 billion euros in the previous tender, but raised their demand for one-week loans to 143 billion euros from 109 billion. That figure rose again on Tuesday with banks taking 166.5 billion euros in seven-day funding to increase gross liquidity in the banking sector to more than 875 billion euros, according to Morgan Stanley. The latest Reuters poll, released on Monday, pointed to a take-up of almost half a trillion euros of three-year money, around the same amount as in December. Around 100 billion euros of that will be rolled out of existing shorter-dated operations, Morgan Stanley calculates.