As US Treasury yields rise, the cost of borrowing short-term US Treasuries surges, prompting traders to aggressively establish short positions.

Borrowing costs for key short-term U.S. Treasuries are soaring as investors borrow heavily from recently issued Treasuries to establish short positions , a phenomenon that could help support U.S. Treasury issuance next week.

With U.S. Treasury yields rising to multi-year highs, borrowing current 2-year and 5-year Treasuries has become more expensive over the weekend. On Friday, the 2-year Treasury yield rose 7 basis points to 4.74%, its highest level since mid-2024.

Rising borrowing costs indicate that traders are willing to pay higher costs to borrow certain U.S. Treasuries in the repurchase market compared to other collateral. This means these bonds are trading in a so-called "special" state, a signal of increased market demand.

John Canavan, an analyst at Oxford Economics, pointed out in a research report:

"Unexpectedly unusual trading conditions are expected in two-year and five-year Treasury bonds before the weekend, as traders prepare for next week's auctions of two-year, five-year, and seven-year Treasury bonds."

Rising yields drive short positions

The continued rise in yields is one of the core drivers of the current increase in repo costs. As yields across all maturities of government bonds generally rise, traders are incentivized to borrow specific government bonds in the repo market to establish short positions, thus being willing to accept higher borrowing costs.

According to data from brokerage firm ICAP, the overnight repo rate for two-year Treasury bonds was around 0.79% on Friday, a further decline from 0.95% earlier in the day (around 7:30 a.m. New York time); the repo rate for five-year Treasury bonds even fell to -0.85% at one point, from 0.29% previously.

In comparison, the repurchase rate for ordinary government bonds is approximately 3.88%. The lower the repurchase rate, the stronger the demand for borrowing this type of bond.

According to CME Group data, the sell-off following the Federal Reserve's interest rate meeting saw a significant increase in risk exposure in front-end to medium-term Treasury futures, consistent with signals of newly established short positions.

The "awaiting issuance" mechanism exacerbates supply shortages.

Besides short-selling, the "when-issued" trading mechanism before government bond auctions is also a significant reason for rising repurchase costs.

Treasury bonds that have been announced but not yet actually issued often trade on the market before the auction. Wall Street traders use these bonds to hedge and quote prices, but because the physical bonds do not yet exist, the actual supply is extremely limited, forcing traders to pay higher borrowing costs in the repurchase market.

This tight supply situation is often seen as a harbinger of a positive auction outlook: a decline in repurchase rates may also mean that bondholders have reduced the amount of bonds available for lending, further tightening market liquidity.

Repurchase defaults rise, Federal Reserve holdings provide a buffer

The market tensions are also reflected in the settlement process. According to data from the Depository Trust and Clearing Corporation (DTCC), the total amount of defaulted U.S. Treasury repurchase agreements (repurchase agreements) on September 17 rose to $67.6 billion, up from $36.7 billion in the previous trading day and exceeding the five-day moving average of $54.7 billion.

However, the Federal Reserve's holdings have provided a buffer for the market to some extent. Since the Fed stopped shrinking its balance sheet in 2025 and has continued to roll over maturing securities in auctions, its holdings of the most recent two-year and five-year Treasury bonds have both been approximately 11.4%, corresponding to approximately $8.9 billion and $9 billion, respectively.

On Thursday, during the Federal Reserve's daily securities lending operations, bids from dealers for both two-year and five-year Treasury bonds were fully met, indicating that current supply is sufficient to meet market demand.

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