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The reluctant credit intermediaries

| September 25, 2020

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.

When the Fed jumped into the market on March 23 and started lifting dealers out of Treasury debt and MBS, one theory had it that the free balance sheet would warehouse other risks. Six months later, that is not the case. The Street shows every sign of reducing risk. It is still long Treasury debt and MBS, although in different proportions. Less liquid assets have less space and arguably less liquidity. For portfolios absorbing the record rise in outstanding credit over the last six months, it comes as the Street seems an increasingly reluctant intermediary.

The primary dealer balance through mid-September has grown by more than $41 billion since the start of the year. It was up by more than $70 billion in the teeth of the crisis in March but has come off since (Exhibit 1).

Exhibit 1: A changing primary dealer balance sheet ($Million)

Note: data show the average primary dealer balance in each asset for the four weeks ending on the indicated date.
Source: Federal Reserve Bank of New York, Amherst Pierpont Securities

The possibility that the Street would clear a part of its balance sheet for less liquid assets has not materialized. The opposite apparently has happened. The asset grabbing the biggest absolute piece of the sheet is Treasury bills, up January to September by more than $61 billion. The next biggest piece has gone to agency MBS, up nearly $20 billion. Agency debentures have grabbed $4 billion. Auto ABS is up a touch. Balances in every other asset class, led by a more than $30 billion drop in Treasury notes, has dropped year-to-date.

The Street balance sheet mix reflects less risk than either at the beginning of the year or during the stresses of March. The share of balance sheet allocated to Treasury bills has vaulted from 6% to 20% (Exhibit 2). Treasury coupons have dropped from 50% to 37%, shortening net Treasury duration. Agency MBS has climbed from 11% in January to 15% in March and has stayed there. Treasury floaters have picked up 1% of the balance sheet, but most other assets show a small decline in allocation.

Exhibit 2: A changing dealer asset allocation

Note: data show primary dealer balance sheet share based on the average primary dealer balance in each asset for the four weeks ending on the indicated date.
Source: Federal Reserve Bank of New York, Amherst Pierpont Securities

The New York Fed’s data on transaction volume paints a picture of market liquidity that runs in parallel to Street positioning. Treasury bill volume is up from the beginning of the year while Treasury note volume is down. Agency MBS trading volume is up, too. Corporate volumes, muni volumes and ABS volumes all generally are down.

Beyond the mix of the primary dealer balance sheet, the Fed’s recent Financial Accounts of the United States shows security brokers and dealers reducing leverage. Total financial assets as a multiple of the difference between assets and liabilities had generally climbed since the start of 2017 except for late 2018, when concern about further Fed hikes led to a widening of risk asset spreads (Exhibit 3). At the close of 2019, the average broker or dealer had $54 in assets for every $1 in proxy equity. That balance dropped in half at the end of the first quarter this year to $27 and finished the second quarter at $28.

Exhibit 3: Brokers and dealers have reduced leverage

Source: Financial Accounts of the United States, Table L. 130, Amherst Pierpont Securities

The Street seems to be following a playbook parallel to commercial banks, which have tightened lending standards to levels last seen in the aftermath of 2008, raised significant balances in cash and added substantial amounts of Treasury debt and agency MBS. Neither the Street nor commercial banks have shown appetite for adding much risk beyond the government markets.

Since the outstanding balance of investment grade corporate debt has jumped $627 billion in the last six month, or 7%, both the largest 6-month gains in at least the last five years, credit is clearly getting absorbed by insurance companies, mutual funds, ETFs and other portfolios. But as these portfolios add risk, the Street’s willingness to intermediate these markets seems to be waning. The Fed may be adding liquidity to the capital markets, but much of it seems to be pooling in the government’s corner.

* * *

The view in rates

The risks in rates continue to tilt toward bearish steeping. That would come with any sign of fiscal stimulus before the November 3 election, given that expectations for now are low. A Democratic sweep would likely sharply raise expectations for fiscal stimulus in the near term and heavier federal spending in the long term. The Fed’s new framework for managing monetary policy—flexible average inflation targeting that only offsets shortfalls in employment—would likely contribute to the steeping. The Fed will likely only tighten if inflation shows up, not necessarily if unemployment runs too low. The new approach could see inflation run clearly above 2.0% and possibly above 2.5% for periods of time before the Fed might act to rein it in. That should pose the most uncertainty and most risk for longer maturities, pushing yields higher as the Fed holds the front of the yield curve down.

The view in spreads

The next leg of tighter spreads looks likely to come after the conclusion of the coming elections. That conclusion may land well after November 3. Spread compression took a holiday in August as spreads broadly moved sideways and interest rate and equity volatility picked up, and that seems a reasonable expectation through November 3 and its aftermath. After final election results, however, an important element of uncertainty should resolve, and risk assets should rally. In the aftermath of elections, risk assets remain caught between Fed buying on one hand and heavy net supply of Treasury debt on the other. There is still fundamental risk in the most leveraged corporate balance sheets with corporate leverage going up through 2020, and only there might spreads continue lagging the rest of the market.

As a side effect of the steeper Treasury curve, projected OAS in MBS should rise as should option-adjusted duration. A steeper curve presents prepayment models with rising rates, and with almost the entire MBS market trading at a premium, rising rates mean slower prepayments and better spreads.

The view in credit

Fundamental credit remains as uncertain as the economy, and the lack of new fiscal stimulus increases risk for households and small businesses. The downside in leveraged credit has outweighed the upside since March, and the imbalance without fiscal stimulus looks likely to get worse. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans suggest distress ahead, despite the broad leveraged loan market completely recouping its losses in February and March. Elevated unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. A rebound in growth in the third quarter should help, but the US has only recouped half of jobs lost since February. The next half looks likely to be harder.

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