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I would give yesterday’s 2-year auction a C+. Not a good sign. To get the bid/cover ratio back to a B+ will require more juice to tempt the carry trade.

Consider it on a leveraged basis. If one had $5mm and some friends in town it would not be at all difficult to borrow $95mm at the repo window and buy $100mm of the two-year note*. Assume that the repo cost is the Fed Funds rate.

If the funds rate is stable at .25% for the next 24 months your equity return is 17%. Not bad. However, if the average Funds rate is 1.08% you breakeven. At an average of 2% you are in the hole by 16%.

That is a terrible ‘rate bet’. No one in his or her right mind would do that. Your upside is capped. It is too easy to have short rates average 1% and break even. And if you woke up one morning with a $ problem all of your equity would be lost.

Do the same analysis assuming the two-year is at 2%. The 20 to 1 leveraged return tops out at 35%. While you will not see that return, the downside would seem remote.

Leveraged players at this big casino seem to be absent. They are just one factor in a very big pie. This carry trade is very tempting. At the right ‘price’ leveraged risk capital will create significant demand for the two year. That price is north of yesterday’s auction. 1.5-1.75% is in the cards.



*I describe the ‘carry trade’ as a buy, borrow and hold transaction. That is not how it works. There are many better ways to achieve this risk profile. However, the economics and pricing of those alternatives reflect the interest differentials. The funding differentials are the backbone of the carry trade. 20 to 1 debt equity is not a big deal. To play at this table you have to have an invite, and a few 100 mil.

Source: Two Year Treasury Note: No Juice for the Carry Trade