The recent crisis in the Repo market last week may have been because the banking industry had gotten used to having only one or two of the big six banks provide last minute loans (Repo transactions) to their peer group and then suddenly these one or two banks simply weren’t available because they found other interesting things to invest in.
Perhaps the banks decided it was worth it to temporarily pay an exorbitant interest rate to buy a two year Treasury Note yielding about 1.7%. The reason: if yields drop to zero then the banks borrow for free while earning a 1.7% yield (actually the yield about 10% more, about 1.9%, since it’s free of state income tax) from a non-callable Note. The bank can then sell the Treasury Note for a gain. If levered up 30 x then the 2% or even 4% capital gain could be a 100% return depending on remaining duration at time of sale.
There has recently been a rumor online about the possibility of buying short term bonds using the futures market and making this type of huge percentage gain, so perhaps these banks decided to take a plunge into the market in hopes of making gains. This is very risky since a sudden spike in interest rates would ruin their bond investment. Assuming they were levered up 30 x they might lose significantly even with a stop-loss order in place, since the bond price could gap down before the stop-loss could be executed.
There is no guarantee that U.S. rates will emulate and merge with the EU’s and Japan’s rates. The EU is a unique, bizarre, man-made economic monstrosity (see this) and is not likely to be something that the U.S. will morph into. Japan could get rid of its government debt with central bank money printing and the debt holders would not create inflation with their buyout cash because rich institutional pension funds don’t cause inflation when they sell an asset. Thus there is the possibility that those countries won’t be getting deeper into negative yields and that the market has already discounted the future U.S. economic slowdown and thus no more huge unanticipated rate cuts. Or the rate cuts can come with whipsaw action that damages leveraged bond traders.
Investors need independent financial advice about the risks of misunderstanding the short term bond market.