September 17, 2012 / 6:23 PM / 5 years ago

Repo rates dip as auctions settle, Fed QE3 adds pressure

The Federal Reserve Building stands in Washington April 3, 2012.Joshua Roberts

NEW YORK/LONDON (Reuters) - Key overnight lending rates dipped on Monday as investors digested $66 billion of U.S. government debt supply from last week and with pressure from the Federal Reserve's latest QE3 stimulus plan to buy mortgage-backed securities.

Investors moved into the overnight repurchase agreement market as the $32 billion of three-year notes, $21 billion of reopened 10-year notes and $13 billion of reopened 30-year bonds that were sold last week settled on Monday.

The Fed's plan to buy $40 billion per month of MBS, announced last week, was also putting downward pressure on repo rates as it tightened the market for very short-dated debt, with that pressure expected to continue, said Alex Roever, short-term rates strategist at J.P. Morgan Securities in New York.

"Unless there is a substantial surge in supply, which we think is unlikely anytime soon, the Fed's commitment to purchase MBS at a pace of $40 billion per month for as long as needed will very quickly exacerbate the existing imbalance between supply and demand," Roever said.

"Ultimately, there is going to be even more cash chasing even fewer assets, which will only push short-term rates even lower," he said.

The interest rate on overnight repos was last quoted at 0.3 percent on Monday, down from 0.37 percent late Friday.

Also in shorter-dated debt markets, the Treasury sold $32 billion of three-month bills on Monday at a high rate of 0.105 percent, which was up slightly from a high rate of 0.1 percent in a similar sale last week.

The Treasury also sold $28 billion of six-month bills at a high rate of 0.13 percent, which was unchanged from a similar sale last week.

Meanwhile, for euro zone money market traders, one big question is driving prices: will the European Central Bank cut the rate it pays on overnight deposits below zero?

The answer has major implications for funds that specialize in eking out a return through short-term lending while keeping risk at a bare minimum for their investors.

"If you lower the deposit facility below zero it will have an amplified effect on all money market papers -- especially those with higher rating -- and will increase the struggle of funds to provide yield to their investors," said Alessandro Giansanti, strategist at ING in Amsterdam.

But, for investment banks trading in short-term instruments, the uncertainty has generated a potentially profitable pricing discrepancy.

The Eonia lending rate, the price the market pays on overnight loans, is heavily influenced by the deposit rate and current levels suggest modest expectation of a cut.

Citigroup strategists say that based on forward contracts there is a 20 percent chance of a cut priced in by February but highlight that the calculation is far from clear because deposit rates have never before fallen below zero in the currency bloc.

Among factors muddying the waters, a cut to below zero could see correlations used for forecasting break down, the central bank could take unforeseen unorthodox policy steps or liquidity could drain from the market and generate volatility.

Using a different forecasting methodology, JPMorgan strategists see the current probability of a cut at 9 percent for next month, rising to 28 percent for a cut in January, while Barclays Capital say the ECB is unlikely to venture into uncharted waters and do not foresee negative rates.

Editing by Chizu Nomiyama

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