It’s a Bad Week to Need to Borrow Five-Year Treasury Notes

(Bloomberg) — The expanding supply of Treasury debt, while driving yields to the highest levels of the year, is also aggravating a shortage of five-year notes in advance of the next auction.

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The root of the problem is that while all Treasury note and bond auction sizes are increasing this month, the sales happen at different times. Three- and 10-year notes and 30-year bonds were sold last week, and two-, five- and seven-year notes will be sold the week after next. Until then, the relative size of three- and 10-year notes has grown relative to five-year notes.

That can be a problem for traders wagering on their relative yield relationships via popular curve or butterfly structures. In particular, leveraged positions expressing the view that five-year notes are overvalued — or too low in yield — relative to three-year notes, 10-year notes or both, are at the mercy of the financing rates that apply to each security, which depend upon supply.

Securities in ample supply can be financed at rates in the neighborhood of the cost of borrowing general collateral in the repo market, currently around 5.3%. Those in short supply can be financed more cheaply, at so-called special rates. In the case of the newest five-year note, which totals $43 billion, the financing rate was as low as 0% on Friday morning in New York, before rebounding to 0.25%, according to ICAP data. Indications for Monday were 3.25%/3.95%.

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A trader with a short position in the five-year note and long positions in the three- and 10-year notes would pay the higher financing rate on the long positions and receive the lower one on the short, jacking up the cost of being in the trade.

Special financing rates for five-year note “makes any underweight-belly trades, either flatteners or butterflies, less appealing,” said Ben Jeffery, a rates strategist at BMO Capital Markets. “It’s just the cost associated with being short the five-year sector.”

Exacerbating the supply imbalance, the Federal Reserve under the terms of its balance-sheet reduction plan didn’t add on to the July five-year note auction for its own account, so there’s only $43 billion of the securities in existence.

By contrast, the Fed obtained nearly $16 billion of three-year notes this month on top of the $42 billion sold to the public, and about $14 billion of 10-year notes in addition to the $38 billion auction.

The next five-year note to be auctioned on Aug. 28 is expected to total $46 billion and to include a Fed add-on of about $5 billion.