The news that the U.S. Treasury is considering issuing bonds that pay negative interest at maturity is a bit perplexing. Why would anyone want to pay to lend money to the government?
The standard answer is that no one would. Instead of lending money at a loss, people would prefer to just hold cash. This is what economists mean when they talk about interest rates having a “zero bound.”
But real yields can go lower than zero — and have in the secondary market for Treasury notes. And, more recently, an auction for six-month notes from the German government produced bonds that pay negative nominal interest.
Now the U.S. Treasury thinks it might have people bidding less than zero for its bills.
How is this possible?
The place to begin is with a strange market event that occurred from August through November of 2003, when a repo rate on a 10-year Treasury went below zero. (There’s a great Fed paper on this here.)
Short-term interest rates were at their lowest level in 45 years in 2003. The low interest rates gave rise to significant settlement problems for those who had shorted the 10-year Treasury note issued in May. In order to obtain the collateral and resolve the fails, market participants were willing to lend cash in repos at extremely low rates. Sometimes, they lent the cash at negative rates.
Why were they willing to lend cash at a negative rate to get their hands on the Treasury note? Typically it was because the costs of the ongoing fails — including the need to set aside additional capital, higher labor costs, and customer dissatisfaction — were rising. The cash lenders determined the expense of paying to lend was less than the expense of continuing to fail.
If the repo rate goes lower than zero, it becomes possible for the underlying bond to also go lower than zero. A market participant who believed that interest rates would remain low for an extended period of time — and therefore the settlement problems of those shorting the bond would continue — would be willing to pay to lend to the government, so long as it was paying less than cash lenders in the repo market.
Eventually, the prices on the repo and the bond should come close to converging.
This isn’t a situation you would expect to last for very long. But it certainly could happen.
The possibility of collateral-driven negative rates may help us understand why we might see some very strange things in the bond market this year.
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