The Big Idea
Out-of-consensus calls on markets in 2024
Steven Abrahams | November 17, 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.
For as long as the Fed keeps policy tight next year, the market is vulnerable to surprises. Those look most likely to flow from declining liquidity, persistent volatility and rising term and spread premium. Returns on assets that do well under those conditions should beat the broad market. The other place where the unexpected waits is in the ongoing withdrawal of the Fed and banks from markets they have dominated for the better part of the last decade. The MBS market looks particularly vulnerable. The out-of-consensus call is to position for these shifts in market regime and structure.
These shifts point to positioning around four major features of the market:
- Lower liquidity
- Persistent volatility
- Rising term and spread premium
- A pivot from policy to private investors
Higher rates have made cash an extraordinarily attractive asset, and money market mutual funds offering market rates have become a cash magnet. If you lump together bank savings and checking accounts with money fund balances and consider the total a measure of the economy’s cash-on-demand liquidity, money funds have spent most of the last decade with a share of less than 25%. Today the share is approaching 28% (Exhibit 1). Those funds invest in a narrow range of assets dominated by RRP, repo and Treasury bills. Every dollar sitting in a money fund is a dollar not invested in a bank loan or investment portfolio or a riskier asset. High rates draw liquidity away from other parts of the market.
Exhibit 1: Money funds have pulled in a rising share of cash-on-demand liquidity
QT then reduces liquidity further by taking dollars out of the market. When a Treasury bill or note or bond sitting in the Fed’s portfolio matures, the Treasury hands cash to the Fed and the cash is retired. Amortization and prepayment of the Fed’s MBS does the same thing. Liquidity dries up. During the current round of QT, cash-on-demand as a share of GDP has dropped from 83% to 75%. And as QT almost certainly continues through next year, the economy will end up operating with progressively less cash-on-demand.
Exhibit 2: QT has reduced Fed balances and cash-on-demand in the economy
Lower liquidity shows up in markets in higher bid-ask, thinner order books, bigger impact from large trade flows and higher intraday dispersion of yields (Exhibit 3). There is a declining balance of cash available to police the market.
Exhibit 3: Fed tightening and QT have coincided with signs of falling liquidity
And beyond the Fed, banks also look likely have their provision of liquidity constrained. Fed Vice Chair for Supervision Michael Barr said in prepared remarks for a recent Congressional hearing that Fed officials were “conducting targeted reviews at banks exhibiting higher interest rate and liquidity risk profiles and conducting focused training and outreach on supervisory expectations about these risks.” Regulators clearly plan to put liquidity under the microscope and have had clear preference in the past for reserves held at the Fed as the gold standard for liquidity.
The ultimate surprise would be a liquidity crisis that pushed funding rates higher or collapsed highly leveraged portfolios or balance sheets. Liquidity seems unlikely to get that low next year.
Declining liquidity should raise the relative price and lower the relative yield of liquid assets in most markets.
Lower liquidity and higher volatility come together. At least that is the case over the last five years. Yield dispersion was low and liquidity high before QT started on June 1, 2022, and dispersion has shifted higher and liquidity lower ever since (Exhibit 4). But even during these shifts in regime, measures of liquidity and market volatility have tracked each other. It seems reasonable that markets with lower liquidity become more volatile with less cash-on-demand to policy pricing anomalies. And tests of Granger causality argue that changes in liquidity cause changes in expected volatility, and not the opposite.
Exhibit 4: Liquidity and volatility track each other before and after QT started
For every material piece of information coming into the market next year, investors will likely have less cash to reallocate to any anomaly in the market.
Rising term and spread premium
Higher volatility should create term premium in rates and credit from investors demanding more compensation to take risk in a volatile market—steepening interest rate curves and steepening credit spread curves from short maturity to long and from highly rated classes to lower. Term premium in the Treasury curve has turned positive several times since Fed policy began draining liquidity and raising volatility in the first half of 2022 (Exhibit 5).
Exhibit 5: Term premium has skewed positive since Fed tightening began
Falling share for the Fed and foreign investors in the Treasury market should further add to term premium. A number of studies (here, here and here) find Fed and foreign buying reduces term premium, so their falling share should reverse the effect. The combined share of the Fed and foreign investors in marketable Treasury debt has dropped from 56% before QT started in June 2022 to 49% recently (Exhibit 6).
Exhibit 6: Combined foreign, Fed share of USTs has dropped from 56% to 49%
Look for ways to capitalize on term premiums in rates and spreads that end the year higher than expected.
A pivot from policy to private investors
The Fed and banks within recent years together have held roughly 66% of outstanding agency MBS, although that share is moderately lower today. The Fed clearly invests because MBS has value for implementing policy, and banks invest in significant part because MBS gets good treatment as a risk-weighted asset and helps meet regulatory liquidity requirements. Those attributes of MBS go beyond the investment risk, return and diversification that private investors usually value. The MBS market in particular is shifting from policy to private hands, and valuations are in motion.
The Fed’s QT has a long way to run, as my colleague Stephen Stanley argues elsewhere in this issue, steadily trimming its share of outstanding Treasury debt and MBS. And banks’ footprint in MBS, already on its way down before the regional bank failures of March 2022, looks likely to only accelerate in the aftermath. New bank regulations will require banks with $100 billion or more in total assets to reflect interest rate risk in their regulatory capital, and banks already are concerned that regulators may put limits on the use of held-to-maturity accounts that often mask interest rate risk in securities held there. Perhaps because of these concerns, my colleague Tom O’Hara in this issue describes how many banks are planning to keep their interest rate risk limited in 2024 and possibly well beyond. Some banks have also mentioned new regulator scrutiny of the liquidity of CMOs. All of this would make holding and managing the negative convexity of MBS much more difficult for most banks than it has been in the past. Banks are likely not coming back to MBS in a material way in 2024.
The ceding of MBS from policy to private hands should continue pushing MBS spreads wider and making them more volatile. For the decade before the Global Financial Crisis when private investors arguably dominated MBS, the OAS on par coupon conventional 30-year MBS ran at a median of 100 bp. In the 15 years since, when policy investors arguably dominated MBS, the median OAS has run at 30 bp (Exhibit 7). With the current par coupon OAS at 50 bp, it should migrate wider, with work by the Federal Reserve suggesting 2 bp of widening for every 1% drop in Fed and bank share of the outstanding market. And with marginal pricing influenced more by private investors—concerned with fluctuating relative value and, for money managers, with the liquidity risk of redemptions—the spread should be more volatile.
Exhibit 7: MBS OAS before GFC ran at a median of 100 bp, after at 30 bp
A comment on credit
High rates will almost certainly continue to put pressure on leveraged corporate balance sheets, many of which are already burning cash. But the pressure seems widely anticipated and largely priced in. If the Fed has to keep policy tight deep into 2024 or even tighten, something Stephen Stanley is anticipating, the all credit spreads could surprise investors by widening sharply.
A comment on timing
The biggest risk to the liquidity, volatility and term premium calls is a rapid change in Fed bias to easing. That is not the base case here at Santander US Capital Markets, but no investor or strategist can rule it out. The market would quickly reprice to improving liquidity, falling volatility and less term premium. Out-of-the-money options on Fed easing could prove valuable.