The Big Idea

The rising price of market liquidity

| February 23, 2024

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.

It’s a bull market these days in securities that an investor can turn easily into cash. That’s clear from a bunch of directions. More liquid instruments trade at higher prices, lower yields, tighter bid-ask spreads and the list goes on. Chalk it up on one side to ongoing QT, which is steadily drawing down the stock of cash in the market. Chalk it up on the other to turbo growth in marketable Treasury debt. In that world, the value of liquid securities goes up.

On-the-run yields drop relative to off-the-run

The value of easily turning securities into cash has gone up worldwide since the Fed and European Central Bank, among others, started tightening financial conditions. Among other things, the daily scatter of on- and off-the-run sovereign yields across different markets reflect it (Exhibit 1). In the US, more liquid on-the-run Treasury debt trades at lower yields than less liquid off-the-run. In Germany, issues deliverable into futures contracts trade tighter. Measures of bid-ask, market depth and price response to big buy or sell orders also send the same signal. In the debt markets these days, owning the most liquid securities comes at a steadily higher price.

Exhibit 1: Rising dispersion of yields reflects a rising cost of liquidity

Note: The index reflects the average difference in yield between sovereign issues with a 1-year or longer maturity and the intra-day Bloomberg relative value curve fitter. In liquid markets, deviations go away quickly, and index values are low. In illiquid markets, deviations persist, and index values are high.
Source: Bloomberg, Santander US Capital Markets LLC.

Rising demand for financing

At roughly the same time that measures of liquidity signal a rising price—or a declining supply of liquidity—the demand to finance Treasury debt has nearly doubled. The balance of Treasury repo transactions tracked by the New York Fed and used for calculating SOFR has moved from around $900 billion in 2021 to around $1.8 trillion in recent months (Exhibit 2). High financing volume likely reflects growth in outstanding marketable Treasury debt, which has gone up since the end of 2021 by nearly $4.2 trillion or nearly 19%.

Exhibit 2: Rising Treasury yield dispersion has coincided with demand to finance

Source: Bloomberg, Santander US Capital Markets

Growing Treasury debt outstrips the supply of potential repo cash

The most likely explanation for the bull market in liquidity is the falling balance of cash available to finance a growing debt market. Hedge funds, for example, can police markets if they can get financing. A fund could buy off-the-run Treasury issues with relatively high yields, for instance, while taking a short position in an on-the-run issue with a matched duration and trading at a lower yield. Leveraging that trade would squeeze the yields of the off-the-run and on-the-run issues closer together. But that requires sizable financing. And since the end of 2021 the size of available financing has fallen relative to the size of the outstanding Treasury market.

Most of the lagging supply of cash for financing Treasury debt and other assets sits either at banks or money market funds. Both suppliers picked up cash indirectly in 2020 and 2021 as federal pandemic programs and QE put cash into the financial system. Bank reserves and money fund AUM combined rose from 29.7% of outstanding marketable Treasury debt in September 2019, the month when repo markets showed stress at the end of the last round of QT, to 39.9% by the end of 2022 (Exhibit 3). But once the most recent round of QE ended in early 2022 and Fed tightening and a new round of QT started, the combined balances failed to keep up with a rapidly growing balance of marketable Treasury debt. Reserves and money fund AUM now stand at 35.9% of outstanding marketable debt, four percentage points lower than roughly two years ago. The financing pool has declined as a share of the financeable market.

Exhibit 3: As a share of marketable Treasury debt, the gap to Sep 2019 narrows

Source: Bloomberg, Santander US Capital Markets

This picture of a declining pool of financing runs counter to a more traditional view that looks at bank reserves as a share of bank assets or that even considers bank reserves and money fund AUM as a share of bank assets. That picture shows a market awash in liquidity. The financing pool grew from 27.5% of bank assets in September 2019 to 39.5% at the end of 2022 (Exhibit 4). The pool then dips and rebounds to stand at 41% of bank assets today. That picture implies financing is at a 5-year peak. But that picture misses the relatively slow growth in bank assets in recent years. The more relevant question is the pace of growth in the financed market—Treasury debt—not in bank balance sheets.

Exhibit 4: As a share of bank assets, liquidity seems well above Sep 2019 stress levels

Source: Bloomberg, Santander US Capital Markets

Treasury debt is not alone

Other markets have also seen big swings in the price of liquidity roughly in parallel with the repricing in Treasury debt. In the 30-year MBS market, for example, the bid-ask for trading TBA 30-year 5.5% pools dropped below 2/32s midway through 2023 just as yield dispersion in the Treasury market dropped, both signals of improving liquidity (Exhibit 5). But as Treasury yield dispersion has picked up since then, the bid-ask on that TBA contract has widened to as much as 6/32s in the last six months and now stands roughly at 5/32s. The bid-ask in other TBA contracts show the same pattern.

Exhibit 5: Bid-ask in 30-year MBS has widened since mid-2023

Note: Bid-ask based on Bloomberg daily closing quotes and shown as a 20-day moving average.
Source: Bloomberg, Santander US Capital Markets.

Liquidity pressure should continue

With QT continuing to pull cash out of the financial system for now and with outstanding marketable Treasury debt in fiscal 2024 set to increase by $1.7 trillion, according to the Congressional Budget Office—faster than US GDP—the price of market liquidity looks likely to keep rising.

Of course, the Fed could pull the plug on QT and end the cash drain. That will depend on when the Fed thinks the system still has ample reserves, which may be too narrow a perspective if the broader goal is a well-functioning financial system including the Treasury market and other capital markets stores of liquidity. Even if the Fed focuses broadly on both reserves and other sources of liquidity and on the functioning of both the banking and capital markets, QT looks like it still has room to run. Using money fund AUM and bank reserves as a share of marketable Treasury debt, we still are well above the levels that triggered the September 2019 stress in Treasury funding markets—the stress that brought the last round of QT to an end.

A continuing draw on cash and a rising demand to finance debt sets the stage for widening yield differences between issues in the Treasury market, widening bid-ask in MBS and a rising price for liquidity in other markets. That tilts relative value in some clear directions:

  • Better in on-the-run Treasuries than in off-the-run
  • Better in TBA and larger specified MBS pool cohorts
  • Better in larger corporate issuers, larger issues and in new issue
  • Better in frequent RMBS, ABS and CLO issuers than in infrequent
  • Wider spreads in MBS and risk asset repo

* * *

The view in rates

The market for now has almost completely converged with the Fed’s view of 75 bp in likely cuts this year. The market priced for 125 bp of cuts before the January 31 FOMC, closed at 100 bp a week and a half later and now stands at 75 bp. The market prices a coin-flip chance of a first cut in June, although Stephen Stanley sees the Fed likely on hold through the November US elections. Implied rate volatility remains elevated on news of bank commercial real estate troubles. And Treasury liquidity remains relatively poor.

Other key market levels:

  • Fed RRP balances closed Friday at $520 billion, down only $12 billion week-over-week but part of a steady trend down since April. Treasury bills and Treasury and MBS repo almost all trade at yields above the RRP’s 5.30% rate, giving money market funds good reason to move cash out of the RRP and into these higher-yielding alternatives.
  • Setting on 3-month term SOFR traded Friday at 533 bp, up 2 bp week-over-week although broadly lower since September.
  • Further out the curve, the 2-year note closed Friday near 4.69%, up 20 bp in the last two weeks. The 10-year note closed at 4.25%, higher by 8 bp in the last two weeks.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -44, flatter by 14 bp In the last two weeks. The 5s30s closed Friday at 9 bp, flatter by 15 bp over the same period.
  • Breakeven 10-year inflation traded Friday at 229 bp, higher by 4 bp over the last two weeks. The 10-year real rate finished the week at 196 bp, higher by 4 bp in the last two weeks.

The view in spreads

Credit has momentum and a strong bid from insurers and mutual funds, the former often funded with annuities and the later getting strong inflows. Liquidity is likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads, leaving them a tad wider than otherwise. Nevertheless, spreads should trade stable to tighter until at least March. The fact that markets have now priced to the Fed dots also looks bullish for credit spreads.

The Bloomberg US investment grade corporate bond index OAS closed lately at 89 bp, tighter by 6 bp over the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 155 bp, wider by 6 bp in the last two weeks. Par 30-year MBS TOAS closed Friday at 47 bp, roughly 2 bp wider over the last two weeks. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer sheets look relatively well protected against higher interest rates, and eventual Fed easing—even late this year—should relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted 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. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

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