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The shifting landscape of liquidity

| September 7, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Fed policy by design moves liquidity around in the fixed income markets, but the Fed’s exit from QE seems be adding a wrinkle to the process. While Fed policy tends to drain cash and liquidity from the system, the flow of assets from Fed into private hands may be adding liquidity back in some sectors. Agency MBS, among other areas, may be benefitting.

Since the Fed started hiking in December 2015, excess bank reserves at the Fed have dropped $506 billion or 22%. Higher rates have helped drain some cash, but the reversal of QE has been just as powerful if not more. Since the Fed started allowing its portfolio to run off just last September, excess reserves have dropped $305 billion.

Exhibit 1: Fed tightening and the end of QE have driven down excess reserves

Source: Federal Reserve

Lower cash balances across the financial system should make cash substitutes more valuable, and trading volume in US Treasury bills and corporate commercial paper suggest activity has picked up. Average daily trading volume in T-bills in the months before and after runoff began—in the 11 months before and after October 1, 2017—has run from $91 billion to $108 billion, a 19% jump. Of course, US deficit spending this year and heavy issuance of T-bills has almost surely contributed, too. So, too, could the flow of Treasury debt out of the Fed’s portfolio and into private hands. But total Treasury debt held by the public is up over the same period by only 5%. Average daily trading volume in commercial paper has jumped from $91 billion to $94 billion, a 4% gain, with almost no change in outstanding balances.

Exhibit 2: Shifts in daily trading volume before and after QE exit

Note: Change in average daily trading volume in the 11 months before and the 11 months after October 1, 2017. Source: Federal Reserve, APS.

The flow of MBS out of the Fed’s portfolio and into private hands also seems to be shaping flows in MBS. Trading in pools is up from $220 billion to $229 billion, a 4% lift. Outstanding agency MBS is also up over the same period by roughly 4%. But volume in MBS dollar rolls is down 13%, possibly reflecting the greater supply of pools for settling TBA trades and consequently the lower likelihood of special financing in that market.

Other major asset categories show a drop in activity. Trading in Treasury notes and bonds has slipped 3%, in investment grade corporate debt by 6% and high yield by 13%. This has come as outstanding balances in investment grade debt over the period have gone up.

The picture painted by changes in trading volume since last September suggest that Fed policy is broadly changing both the level and allocation of liquidity. Assets that substitute for cash or that are passing from Fed to private hands are seeing liquidity pick up while other sectors are seeing liquidity drop. That’s a valuable clue about what lies ahead.

* * *

The view in rates

An above consensus employment number on Friday sparked a 6 bp sell-off, pushing the 10-year Treasury yield back into the mid-2.90s and re-flattening the curve. That’s dead center in the 2.78% – 3.11% range it’s been trading in since February. Next week is heavy with data, and it looms larger with the FOMC’s next rate hike dialed in for later this month. The 10-year should hit 3.00% with a continued modest flattening of the curve on strong economic data. The spoiler could be renewed noise on tariffs or contagion emanating from emerging markets.

The view in spreads

The Fed’s steady draining of liquidity from the markets and a continuing build-up in corporate leverage—the Cigna-Express Scripts deal just the latest example—should keep pressure on spreads. The risk profile of the aggregate investment grade corporate portfolio keeps rising. Spreads should widen as compensation. Agency MBS, meanwhile, may widen slightly in sympathy. But MBS also benefits from liquidity. The relatively flat spread curve from the riskiest to the safest credit should steepen.

 The view in credit

Rising leverage poses the clearest risk to fundamental corporate credit while rising interest rates pose the clearest risk to leveraged loans. Since most leveraged loans float off of 1- or 3-month LIBOR, rising rates should keep pressure on interest coverage ratios. Household balance sheets still look relatively strong, although households with student debt continue to find themselves under pressure.

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