The Big Idea
Tradeable implications of deposit instability
Steven Abrahams | March 24, 2023
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.
Jay Powell took the lead role in market action after the March FOMC, but Janet Yellen stole the scene when her testimony before Congress walked back suggestions of a blanket federal guarantee of bank deposits. Yields fell across the curve, and the market held on to its worries about runs on uninsured deposits. Banks also seem worried, and laser focused on liquidity. Until the market sees US bank deposits as stable, look for a steeper yield curve and wider spreads on bank CDs and on assets where banks traditionally invest, especially MBS.
The tradeable implications:
- A steeper 2s5s and 2s10s yield curve
- Wider spreads on brokered and institutional bank CDs
- Wider OAS on agency MBS, especially in coupons around par
- But tighter spreads on agency CMBS and other hedge-able cash flows
A steeper yield curve
A steeper yield curve reflects constraints banks now face with deposits and the impact of those constraints on bank lending and investing. At the end of 2022, the average bank had 43% of its deposits uninsured. If banks have to manage as if those deposits could run, it becomes hard to put money into loans and securities. Since the collapse of SVB, banks have put nearly $530 billion into reserves at the Fed instead of into loans or securities. That has immediate implications for credit and portfolio investment:
- On credit, pulling back on lending obviously slows the economy, lowers the trajectory of fed funds and lowers the fair value yield on short debt. Fed funds futures and OIS have repriced that way. Of course, It is too early to tell how much tighter credit will become. But tight credit has been the single best predictor of recession of the last 30 years.
- On portfolio investment, banks and their regulators look highly likely to keep a much tighter limit on mark-to-market interest rate risk, learning lessons from SVB and improving their chances of liquidating securities in the future without taking losses that imperil capital. Before it collapsed, SVB has sold its entire available-for-sale securities portfolio and reallocated into Treasury debt, and then it swapped the Treasury debt into a floating rate. Other banks may not be that extreme, but bank demand for the front end of the curve is likely to go up and, all else equal, steepen the yield curve
Wider spreads on brokered and institutional bank CDs
With deposits in flux, the value of funding with defined maturity goes way up. This trend already started last year as banks tried to lock in CDs as QT pulled deposits off the balance sheet. From January 2022 through early March 2023, the Fed’s H.8 reports show CDs of $100,000 or more at US commercial banks rose by more than $300 billion, or nearly 30%. Despite wide spreads since SVB collapsed, a wide range of banks have continued to offer brokered and institutional CDs. This is showing up in the spread between 3-month SOFR and 3-month LIBOR, which is heavily influenced these days by spreads on bank institutional CDs. That spread since March 7 has widened 33 bp. CD supply should remain heavy and widen spreads in that market.
Wider OAS on agency MBS, especially in coupons near par
The lessons of SVB will also likely penalize holdings of MBS, which, besides being negatively convex are also more complicated to hedge than competing assets. Banks hold around 40% of outstanding agency MBS and primarily buy MBS around par, so any change in appetite has a material impact on spreads. Some MBS cash flows may still work, such as CMO floaters or short, stable CMO sequential classes. But other MBS cash flows would need last-of-layer hedging that needs monitoring and remains subject to the risk of becoming ineffective. Meanwhile, MBS will compete against assets easier to hedge. If there’s any good news here for MBS, it is that Treasury OAS has already widened this year toward 50 bp and historically would only need another 10 bp or 20 bp to find a good bid from other buyers.
Tighter spreads in agency CMBS and other hedge-able cash flows
The relative ease of hedging agency CMBS, municipal securities and some other cash flows should tighten spreads in these sectors over time as bank portfolio investments migrate away from agency MBS. Agency CMBS has relatively stable cash flows where banks can readily get hedge accounting for swaps that shorten their duration or turn them into floating-rate instruments. Even though municipal securities often are callable, banks may be able to get hedge accounting for the swaps and swaptions needed to turn them into floating-rate positions. Anecdotally, agency CMBS has performed relatively well in the aftermath of SVB as investors start to see the appeal of swapable cash flows.
An immediate solution to deposit concerns is not obvious
Regulators continue to wrestle with the difficult job of stabilizing the US bank deposit base. The FDIC can only guarantee deposits up to $250,000, and only make higher limits widely available with the approval of Congress. Congress could also raise the limit through legislation. Hence the Treasury secretary’s wet blanket on blanket guarantees. The Dodd-Frank Act took away authority used by the FDIC in 2008 to guarantee all deposits, leaving it with more narrow rights to make a “systemic risk exception” and guarantee deposits only after a bank goes into receivership. Uninsured depositors may not want to wait for an FDIC rescue and risk standing in line behind the FHLBank system and the federal government.
Policymakers have started considering other solutions short of legislation:
- Signaling that the FDIC would routinely use a “systemic risk exception” for all failed institutions, although this becomes a harder case to make as bank size goes down
- Using the Treasury’s Exchange Stabilization Fund to provide a temporary guarantee, although Treasury would have to justify protecting the deposits of corporations and wealthy individuals
Politicians have started floating bipartisan ideas for new legislation. The proposals so far include:
- Lifting the guarantee limit altogether, although the FDIC insurance fund today only holds $128.2 billion or 1.27% of outstanding deposits and would have to get much bigger
- Lifting the limit for transaction accounts, especially for smaller banks
Congress has lifted the deposit limit six times since World War II, the last time in 2010, typically as average deposit balances rise across the banking system. This could happen eventually but looks unlikely anytime soon unless banks see broad evidence of a run on uninsured balances.
While concern about deposits continue to percolate, debt investors have a range of tradeable opportunities. And even after acute concerns go away, the collapse of SVB has set things in motion that should shape the debt markets for years.
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The view in rates
OIS forward rates even after the March FOMC anticipate no more hikes in Fed funds this year and cuts in late summer or early fall. The Fed will have to balance the impact of SVB on bank credit against its competing commitment to beat persistent inflation.
Fed RRP balances closed in the last few days at $2.22 trillion, up $112 billion from a week ago. Money market funds through March 22 saw $117 billion of inflows, so that would be feeding the RRP balances.
Settings on 3-month LIBOR have closed Friday at 510 bp, up 10 bp on the week. Setting on 3-month term SOFR closed Friday at 488 bp, up 3 bp on the week. The spread between these benchmarks is 33 bp wider since March 7.
Further out the curve, the 2-year note closed Friday at 3.77%, down 7 bp on the week. The 10-year note closed at 3.38%, down 5 bp on the week.
The Treasury yield curve has finished its most recent session with 2s10s at -40 bp after hitting -108 bp on March 8. The 5s30s finished the most recent session at 23 bp after hitting -46 bp.
Breakeven 10-year inflation finished the week at 221 bp, up 11 bp in the last week. The 10-year real rate finished the week at 116 bp, down 17 bp in the last week.
The view in spreads
Volatility has rocketed in the aftermath of SVB, with the MOVE index reaching levels last seen in 2008 and 2009. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 154 bp, down 2 bp on the week. Par 30-year MBS TOAS has closed Friday at 46 bp, tighter by 4 bp on the week.
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.