The steady flow of U.S. government debt flooding the nation’s bond market has failed to raise bond yields – with the exception of those in the market for short-term securities. The cost of overnight borrowing is elevated in the market for repurchase agreements (repos), where money-market funds make short-term loans to bond brokers, typically using government debt as collateral. The overnight rate on Treasury repos was 2.47% Friday, July 19, markedly higher than the 2.35% rate for interest on excess reserves, or IOER, and the 2.048% rate for 10-year Treasury notes.

The rising supply of U.S. government debt weighs heavily on bond dealers, producing the rate gap between the market for repurchase agreements and interest on excess reserves. The Fed’s network of primary dealers, responsible for bidding at government debt auctions, held $238 billion in securities on July 10. Last summer, those securities were worth almost $100 billion less. Bondholders seek ways to benefit from the excess holdings, and repo trades provide a valuable channel.

The surplus of bonds in the overnight market has forced bondholders seeking cash to offer higher yields. “It’s been quite welcome,” said Deborah Cunningham, who oversees money-market funds for Federated Investors. She frequently holds more than half of her assets in overnight repos.

Repo trades are a key component of the Secured Overnight Financing Rate (SOFR), a new interest rate benchmark introduced by the Federal Reserve Bank of New York. Policy makers will have to navigate the rising supply of federal debt in domestic bond markets as they adopt SOFR as a replacement reference rate.

Repo rates are expected to fall as the Fed gears up to cut interest rates later this month. Yields on other securities could fall even further, as their longer maturities reflect expectations for additional rate cuts in the future.

“If you have cash, you’re definitely being compensated for being in repo,” said Thomas Simons, a money-market economist at Jefferies Financial Group. “It would behoove you to continue concentrating in the short-term because rates are definitely heading lower.”

Read More via The Wall Street Journal