The borrowing needs of the U. S. Treasury dominated the fixed-income markets last week, and although the issues sold satisfactorily, the seeds for future market problems may have been sewn. On Monday, the Treasury sold $11 billion three- and six-month bills; on Tuesday and Wednesday the $11 billion quarterly refunding was auctioned, while on Thursday the sale of the $6.25 billion year bill finished the Treasury's activity for the week. The bottom line was: four Treasury sales with total gross borrowings of $28.25 billion out of which $9.68 billion represented new money.
In retrospect, the two recent discount rate cuts to 11 percent by the Fed, plus the ease that has occurred in the banking system, was probably partially carried out with the hopes of creating a better market environment in which the Treasury could sell its securities. If this in fact was their aim, the Fed was successful, as only the three-year note auction was on the sloppy side. Although none of the issues was a ball of fire, the market handled them reasonably well, considering the size of the issues. However, it is estimated that the New York government dealers purchased 78 percent of the three year note, 90 percent of the 9 3/4 year, and 88 percent of the year bill.
The Treasury's heavy reliance on the dealers to purchase and distribute their many sizeable issues places both the dealers and the market in a vulnerable position. Up until mid-week, the dealers had been able to carry their sizeable positions at an advantageous cost to them. The dealers owned government securities that were returning 12 to 14 percent. They were able to carry or finance these securities by doing repurchase agreements with their customers. In this situation, the dealers put their securities up as collateral against the use of their customers' cash. The customers, in turn, are paid a rate of interest for their cash--known as the repo rate. For the last few weeks, the repo rate had been way below the returns that the dealers were earning on their position. When this occurs, the dealers are said to have a positive cost of carry. Recently, this positive cost of carry, or spread, was as much as 250 to 300 basis points.
This large spread is partially explained by the phenomenal growth in the assets of the money market funds to $216 billion.
This growth is because of the fact that the yields on the funds have lagged the interest rate declines on the various money market securities, especially T-bills. The funds have used this excess cash to enter into repurchase agreements with the dealers, which has helped to lower the repo rate to the 7 5/8 to 9 1/2% level. However, on the day that a new issue settles and must be paid for, the supply of net new securities that must be financed rises and forces the dealers to pay a higher rate of interest to attract the funds necessary to finance their unsold positions. The overnight repo rate climbed to 10 3/4 percent by Friday, after two issues settled at mid-week. When their positive cost of carry, or spread, shinks, dealers begin to ask themselves--especially in the face of $9.68 billion of net new securities that will be settling over the next two weeks--if the positive cost of carry is large enough to compensate them for their risks of holding large positions where they could be seriously hurt if the market were to suffer a reverse because of some unforeseen event.
Right now, dealers are extremely nervous, and feel vulnerable, owning large positions, knowing of the huge Treasury financing job yet to be done and with the talk on the escalating size of the deficits. If it weren't for the weak economy and the slowdown in the demand for short term funds, both prices would be headed south.
On Tuesday, $23 billion of tax exempt project notes will be offered with maturities in December of 1982 and January, February and March of 1983. These HUD backed notes should return between 6 3/4 and 7 percent. On Wednesday, Pennsylvania will offer $450 million in tax anticipation notes due in June of 1983. These MIG-1 rated notes should return around 8 1/2 percent.