Carter Dayne
Uncertainty over the possibility of a substantial interest rate cut by the Federal Reserve in September has driven borrowing in short-term US Treasuries to recent highs.
In recent weeks, borrowing activity in the price-sensitive short-term US Treasury bond market has intensified. Based on economic data, markets are currently pricing in a 100% probability of a rate cut in September. However, the magnitude of this cut remains uncertain. Some market participants expect a slowdown in the US economy to trigger a substantial 50 basis point reduction, while others argue that recent strong retail sales figures reduce the likelihood of an imminent recession, supporting the idea of a smaller 25 basis point cut.
This uncertainty about the size of the next rate cut has led to an increase in the value of US Treasury Bills (with maturities of less than one year) and Bonds (with maturities of Fixed-income assets with shorter maturities are particularly sensitive to price fluctuations and tend to respond more acutely to any market mispricing. Investors are likely to be borrowing short-term Treasury bonds in anticipation of various potential scenarios that may unfold in the coming weeks.
Anticipation of a smaller than expected cut
If some investors believe that the market is too optimistic and expects a large rate cut, they might short bonds, anticipating that the actual cut will be smaller than expected. A smaller-than-expected cut could disappoint the market, leading to higher yields (and lower bond prices), making a short position profitable.
Overreaction and market correction
When there is uncertainty, markets can sometimes overreact to the possibility of a significant cut, causing bond prices to rise more than economic fundamentals would justify. If investors expect the market to correct after the rate cut decision is announced (especially if the cut is minor or if there is no cut at all), they might short bonds in anticipation of a price decline.
Hedging against the risks of rising interest rates
In an uncertain environment, there is always the risk that, rather than cutting rates, the central bank will choose to keep them unchanged or even raise them if inflation or other economic data surprise to the upside (any hike seems unlikely in the current situation). Short-selling bonds can be a way to protect against this risk, as bond prices would fall if rates were not cut as expected or if an unexpected hike were to occur.
Yield Curve Dynamics
Uncertainty about the magnitude of the rate cut can lead to varying expectations about the shape of the yield curve. If some investors believe that a smaller cut or no cut will lead to a steeper yield curve (where long-term rates rise more than short-term rates), they might take short positions in short-term government bonds as part of a strategy to take advantage of this move.
Counter game
In a high uncertainty environment, if the majority of the market is positioning for a large rate cut, a contrarian investor might short bonds with the expectation that the consensus view is wrong and that the rate cut will be smaller or that other factors will cause bond prices to fall despite the cut.
One of the most sought-after US Treasury bonds in the securities lending market is the 0% 20/03/25. The value of the loans has been growing since early July, with balances fluctuating with market activity. S&P Global Market Intelligence Repo Data Analytics also shows that this issue is trading particularly high in the repo market, with volumes reaching all-time highs on August 14 at over $520 billion.
Regardless of the outcome of the Federal Reserve’s September meeting, prevailing market sentiment will continue to influence activity within the securities lending markets. The current uncertainty surrounding the future path of interest rates, coupled with speculation about the final target rate, is expected to increase volatility in fixed-income markets in the coming weeks and months. Investors are likely to continue to position themselves to manage risk and potentially profit from market mispricing in this volatile and uncertain interest rate environment by taking advantage of the liquidity provided by the securities lending market.
Editor's note: The summary points in this article were chosen by Seeking Alpha editors.