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Fed therapy for the funding markets

| October 4, 2019

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.

The Fed continues to come to the aid of a nervous funding market. Friday afternoon the Fed announced it will offer at least $75 billion in overnight loans against Treasury and agency debt and MBS from October 10 through November 4 and offer $35 billion to $45 billion in new 6- to 15-day term loans through October 29. The Wall Street Journal also reported that on October 10, the Fed may vote on rules proposed a year ago that fortuitously could ease some of the frictions currently limiting the flow of cash from bank reserves into repo. The vote could be timely. All signs point to limited private cash for financing US Treasury debt and other fixed income assets.

The unexpected September 17 spike in Treasury repo and other overnight financing rates has prompted a hunt for plausible cause, and bank liquidity and capital regulations increasingly look suspect. Banks currently hold nearly $1.3 trillion in excess reserves at the Fed earning IOER of 1.80%. Those funds in theory should reach for the higher yields of repo until the markets converge. But continuing Fed operations indicate that is not happening.

Frictions from liquidity regulations

An excellent analysis by the Bank Policy Institute points to the possible frictions in flow of bank funds from reserves into repo, starting with liquidity regulations. Banks have to hold high-quality liquid assets, or HQLA, to meet requirements of the Liquidity Coverage Ratio, and reserves get the highest possible treatment under HQLA. Banks can move reserves into a reverse repo against Treasury debt, and the transaction also gets the highest treatment under HQLA. On the surface, nothing changes.

But the largest banks also have to meet non-public liquidity stress tests, resolution and liquidation requirements and bank examiner expectations that apparently create a strong preference for cash over even Treasury collateral. A survey of banks by the Bank Policy Institute suggests reserves have important value for meeting liquidity regulations beyond their value for earning interest. Since the largest banks also happen to be the largest repo dealers, liquidity regulation looks like it has trapped cash in the banking system.

Frictions from capital requirements

Moving reserves into Treasury reverse repo also has capital implications. Reserves have a 0% risk weight while Treasury reverse repo does not, although haircuts can bring the weighting down sharply. For global systemically important banks, or GSIBs, doing the reverse repo with a foreign entity, including a branch of a foreign bank, increases measures of cross-jurisdictional risk. GSIBs have to hold capital against cross-jurisdictional exposures, and the capital schedule moves in 50 bp increments. Any transaction that cross a line in the schedule could push up required capital by 50 bp against the bank’s entire balance sheet.

Rather than tapping reserves, banks could borrow to lend into repo, but that, too, inflates the balance sheet. That puts pressure on bank capital ratios, although a few days of higher leverage probably have limited impact outside of quarterly reporting dates. And again for GSIBs, borrowing in wholesale markets increases measures of systemic risk and opens the door to a capital surcharge.

Diagnosis, then treatment

The Fed ultimately will need to investigate these and other plausible explanations of the recent funding market stress before delivering a credible solution. Pouring cash into the market is, at best, a temporary fix. If capital is the binding constraint, for instance, a standing Fed repo facility may not work as expected. Borrowing from the Fed to lend into repo would still balloon participant balance sheets and, for GSIBs, risk an increase in capital surcharge. It may be more effective for the Fed to buy Treasury debt for its own portfolio. That would reduce the volume of positions that need financing and add cash to the market without hitting the liquidity or capital tripwires at banks.

Investment implications

The ongoing hunt for the cause of repo stress has started to put pressure on assets sensitive to the availability and stability of wholesale funding. Since September 16, bank equity has steadily underperformed the S&P 500 and the debt of banks that rely heavily on wholesale funding have widened to their retail-funded peers. More generally, continuing uncertainty around financing stands to put pressure on a wider range of assets that routinely rely on financing at some point, even if only in transit through broker/dealer balance sheets. The market has clearly taken comfort from the Fed’s efforts to put cash into repo, but that comfort stands to end with the Fed’s efforts until a plausible explanation for the current situation is found and a targeted solution delivered. Stay tuned.

* * *

The view in rates

The market has priced another Fed cut this year at more than 90%, not a stretch given the FOMC’s earlier indications that another cut or two in fed funds should be enough to help growth and eventually tip inflation back towards its 2% target. Stephen Stanley makes a good case this week that inflation already is trending back toward target, focusing on the Dallas Fed’s trimmed measure of inflation. But rates of inflation and growth implied by 10-year notes and TIPS nevertheless remain low. Our position: neutral on rates.

The view in spreads

The spread markets have repriced to higher levels of volatility and a Fed inclined to keep financial conditions easy. Most credit spreads have tightened. MBS has lagged credit for reasons that Brian Landy points out this week, namely the heavy volumes of refinanced loans flowing through the market. MBS spreads should stay soft through the balance of the year and start to tighten thereafter.

The view in credit

Slowing global growth will almost certainly catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

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