As US Treasury yields rise, the cost of borrowing short-term Treasuries surges, with traders aggressively building short positions

As investors heavily borrow recently issued US Treasuries to establish short positions, the borrowing costs for key short-term US Treasuries are soaring, a phenomenon that may help support the issuance of US Treasuries next week.

As US Treasury yields climb back to multi-year highs, the cost of borrowing current 2-year and 5-year Treasuries over the weekend has become even more expensive. On Friday, the 2-year US Treasury yield rose 7 basis points to 4.74%, marking the highest level since mid-2024.

The rise in borrowing costs indicates that, in the repo market, traders are willing to pay higher costs to borrow specific US Treasuries compared to other collateral. This means these bonds are trading in a so-called "special" status, signaling increased market demand.

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

"The 2-year and 5-year Treasuries are likely to experience unexpectedly special trading status before the weekend, as traders position themselves ahead of next week's auctions of the 2-year, 5-year, and 7-year Treasuries."

The persistent rise in yields is one of the core drivers behind the recent increase in repo costs. As Treasury yields rise across all maturities, traders are incentivized to borrow specific Treasuries in the repo market to establish short positions, making them willing to accept higher borrowing costs.

According to data from broker ICAP, the overnight repo rate for borrowing current 2-year Treasuries on Friday was about 0.79%, lower than earlier that day (around 7:30 AM New York time) when it was 0.95%. The repo rate for the current 5-year Treasuries even dropped to as low as negative 0.85% after previously being quoted at 0.29%.

In comparison, the repo rate for regular Treasuries is around 3.88%. The lower the repo rate, the higher the demand for borrowing that security.

According to CME Group data, in the post-Fed meeting sell-off, a large amount of risk exposure was added to short- and medium-term Treasury futures, consistent with signals of new short positions being established.

Beyond short positioning, the "when-issued" trading mechanism ahead of Treasury auctions is also an important reason for the rise in repo costs.

Treasuries that have been announced but not yet physically issued are often traded in the market before the auction. Wall Street dealers use these when-issued Treasuries for hedging and quoting, but since the physical securities do not yet exist, the actual supply is extremely limited, forcing dealers to pay higher borrowing costs in the repo market.

This supply tightness is generally seen as a sign of strong auction prospects: declining repo rates may also indicate that holders are reducing the amount of securities available for lending, further tightening market liquidity.

The tight market environment is also reflected at the settlement level. According to data from the Depository Trust & Clearing Corporation (DTCC), the total daily US Treasury repo fails reached $6.76 billion on September 17, up from $3.67 billion the previous trading day and above the five-day moving average of $5.47 billion.

However, the Fed's holdings have provided some market buffer. Since the Fed stopped balance sheet reduction in 2025 and continued to roll over maturing securities at auctions, its holdings of the most recent 2-year and 5-year Treasuries are both around 11.4%, corresponding to about $890 million and $900 million, respectively.

On Thursday, the Fed's daily securities lending operation saw dealers' bids for the 2-year and 5-year Treasuries fully met, indicating that current supply is still able to meet market demand.