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Connecting dots

admin | October 11, 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. This material does not constitute research.

The Fed’s apparent misjudgment of required reserves in the banking system and the recent accelerating drop in leveraged loan prices should give fixed income investors pause. Things are shifting in fixed income, and not necessarily in transparent ways. Insufficient liquidity and weakening credit usually are not a good combination. This time may be different, but both risks are in play.

A misjudgment of liquidity

The Fed’s misjudgment of system liquidity is clear in the magnitude of response since repo rates first spiked higher on September 16. The Fed started on that day with operations to add $75 billion of overnight cash, added term operations within days, and eventually extended both programs into early November. Now, on October 11, the Fed announced overnight and term lending through January and has added monthly purchases of approximately $60 billion in Treasury bills into the second quarter of next year.

All of these efforts push cash into the banking system and implicitly acknowledge that the level of excess reserves needed for smooth funding markets fell too low. That was despite $1.26 trillion of excess reserves as of September 18 (Exhibit 1). That is not to fault the Fed. This is the first time the Fed has had to draw down an excess reserve regime. The Fed’s own estimates of proper reserves have varied widely at different times, and the Fed’s own survey of primary dealers in March showed a median expectation of $1.2 trillion in required reserves. At this point, the right level for now clearly is higher.

Exhibit 1: Excess reserves have dropped sharply from their peak

Source: Federal Reserve

The challenge is that the cause of repo stress is not fully understood. There are theories: liquidity regulations that give banks strong incentives to hold onto excess reserves despite rates in other markets well above IOER, and capital rules that potentially penalize the largest banks for repo generally and with foreign counterparties in particular. Some analysts have pointed to the Treasury’s post-crisis decision to place tax receipts in an account with the Fed instead of putting deposits in banks, and some have noted the Fed’s decision to do reverse repo with about 250 central banks, governments and international institutions to the tune of $300 billion, taking another source of funds out of the private repo markets.

For now the Fed is responding with a phalanx of efforts to address all possible causes. The good news is that it’s working. The bad news is that private markets have no incentive to figure the problem out. That leaves the possibility of surprise or unintended consequences of the cash injections.

Eroding credit

Injection of significant liquidity normally would be a balm to concerns about credit, but the $1.2 trillion market in leverage loans does not seem to feel that way. The price of the average leveraged loan has slowly fallen since early May, and the drop recently has accelerated (Exhibit 2). That also comes despite lower short-term rates, which offer direct relief to balance sheets largely financed with floating-rate debt.

Exhibit 2: A drop in leverage loan prices has accelerated lately

Source: Bloomberg, S&P

The falling value of an average leveraged loan almost certainly reflects eroding credit. The share of leveraged loans with a rating of ‘B+’ or lower has climbed steadily since early 2017 and has accelerated this year (Exhibit 3). Spreads on loans with a ‘B+’ or lower rating have also widened by 50 bp since late July. Leveraged loans would be the first part of the market likely to feel the impact of a slowing economy, and growth has been decelerating.

Exhibit 3: Accelerating weakness in outstanding leveraged loans

Source: LCD

Investment grade and high yield corporate debt have done far better than leverage loans, by the way, so this is not a generalized corporate credit event. Those markets are largely fixed rate and less sensitive to immediate funding conditions.

It can be a volatile mix when the need to harbor liquidity and concern about asset value come together. The repo market for Treasury and agency debt and MBS is obviously far away from the market for funding leveraged corporations. The Fed is helping to ensure plenty of distance remains between those dots for now. But plenty of episodes of stressed liquidity and shifting asset value have ended poorly. Two dots that few investors would want to connect are nevertheless in play. It is worth watching them both.

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The view in rates

The market this week lowered its odds of another Fed cut this year from more than 90% to only 82%, at least after news of a possible pause or truce in the US-China trade war. Nevertheless, no one can predict the next steps in that negotiation since it still remains a largely political process. That makes it hard to be anything other than 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 outside of leverage loans. MBS has lagged credit and should continue to trade at soft spreads largely due to 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.