The Big Idea

The rise of Wall Street balance sheets

| June 28, 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.

Wall Street now holds its biggest inventory in debt securities in at least five years, likely a testament to the profitability of holding and trading positions. The Street relies heavily on markets to fund and hedge itself, but there’s barely a ripple to suggest any trouble accommodating the higher demand. Under these circumstances, Street balance sheets look likely to continue growing until financing markets wave the caution flag.

The highest balances in five years

Wall Street carried more than $485 billion in debt securities as of early June, its biggest inventory in at least five years (Exhibit 1). Primary dealer holdings have jumped nearly 2.5 times since 2022 after the Fed started to hike and let its Treasury and MBS holdings roll off through QT. This year alone, inventory has grown by nearly $101 billion or 26%.

Exhibit 1: Primary dealers hold the most inventory in at least five years

Source: Bloomberg, Santander US Capital Markets.

A leveraged, hedged balance sheet

Dealers occupy a unique position as collectively the largest holder of debt securities funded through repo and other market sources and usually hedged against interest rate and other risks. Only mortgage REITs come close. The Federal Home Loan Bank system is also leveraged and hedged, although FHLBanks rely on debt for funding. The growth of dealer balance sheets creates demand for financing and hedging.

Most of the rise dealer inventory in the last few years has come in Treasuries, which now tally $325 billion. Dealers also hold $114 billion in MBS, $23 billion in corporate debt, $14 billion in agency debt and $9 billion in ABS.

Most of the Treasury growth has come in Treasury bills and in notes with 3- to 6-year maturities (Exhibit 2). Bills have grown by $58 billion since mid-2022 and 3- to 6-year notes by $54 billion. Other maturities also are up, but by a fraction of these amounts.

Exhibit 2: Most of the Treasury growth has come in T-bills, and 3- to 6-year notes

Source: Bloomberg, Santander US Capital Markets.

The changing size and mix have affected dealer risk. The growth in bills and intermediate notes have helped bring the estimated duration of the position down from nearly 9 years in mid-2022 to around 5.5 years today. But the rising absolute size of the position has offset the drop in duration, and the estimated DV01 or dollar risk of the position has doubled from roughly $80 million to more than $160 million today (Exhibit 3).

Exhibit 3: Position duration has dropped, but risk or DV01 has doubled

Note: duration estimated by taking the mid-point of each reported UST maturity category and weighting it by the par balance in the category as a share of the total, DV01 by weighting it by the absolute amount. Category (Duration): T-bill (0.5), N<2 (1), N2-3 (2.5), N3-6 (3.5), N6-7 (6.5), N7-11 (9), T11+ (18).
Source: Bloomberg, Santander US Capital Markets.

Balances reflect opportunity

Like any investment portfolio, dealers are in the business of making money and dealer inventory should say something about opportunity. The rise in Treasury debt reflects a favorable mix of leverage, funding and carry, hedging, bid-ask and capital treatment for the product. The particulars:

  • Leverage. Haircuts on overnight Treasury repo have routinely dropped below the usual 2% since mid-2022, often dropping to 1% and occasionally to 0%, improving potential return on equity (Exhibit 4).

Exhibit 4: Available leverage on Treasury debt is high

Source: New York Fed, Santander US Capital Markets.

  • Funding and carry. Funding rates for general Treasury collateral have frequently run below the yield on T-bills, allowing dealers to hold bills and collect positive carry (Exhibit 5). At high levels of leverage—and with overnight rates high—a few basis points of spread can still generate acceptable return on equity.

Exhibit 5: T-bills since early 2022 have had positive carry

Source: Bloomberg, Santander US Capital Markets.

  • Hedging. Primary broker Treasury desks often hedge notes and bonds with futures, and the Treasury cash-futures basis—the expected profitability of owning the cheapest-to-deliver Treasury hedged with a short position in the futures contract—has been generally positive since mid-2022. For desks that also hedged with swaps, fixed rates on SOFR contracts have consistently run below Treasury yields, allowing those desks to hedge interest rate risk on 5-year and other maturities and pick up spread (Exhibit 6).

Exhibit 6: Owning 5-year notes and hedging with swaps has been positive spread

Source: Bloomberg, Santander US Capital Markets

  • Bid-ask. Bid-ask on Treasury debt has also widened, giving dealers more opportunity to add to returns by holding inventory and re-trading, although wider bid-ask is offset by declining liquidity, making it harder to re-trade large blocks.
  • Capital treatment. A 0% risk-weighting for Treasury debt make it easier for brokers affiliated with banks to carry positions.

No signs of stress

Despite the rising dealer balances of Treasury debt, MBS and other assets, the fundings markets have absorbed the demand smoothly. Repo rates on Treasury debt and MBS may rise at the end of a month or the end of a quarter, but the rate premium is usually a few basis points and goes away quickly. That undoubtedly reflects continuing ample reserves in the banking system and a money market fund complex that has a record of more than $6 trillion in cash that it routinely deploys in part in repo.

There’s also no sign of stress in the futures or swaps markets that might be used to hedge interest rate risk. Holdings in MBS, which occasionally have added volatility to hedging markets as desks delta hedge positions, are 23% of primary dealer positions—enough to matter, but not enough to push derivative markets around.

Rising dealer balances could matter more as the Fed continues QT and draws down the stock of cash in the financial system. Rising demand for dealer financing and a falling supply of cash could squeeze financing markets. That will probably be the point where dealers begin to pare back positions. Until then, Street positions look likely to continue growing.

* * *

The view in rates

Fed funds futures now price in 45 bp of easing this year as of the Friday close, down 3 bp from a week ago. The market sees a 56% chance of a cut in September and a 76% chance of December. The Fed keeps saying it will need to see several months of benign inflation readings and the May report has started the clock. If June and July also show benign month-over-month inflation, that could set up the Fed for a September cut. The PCE core index for May arrived with an expected and benign 0.1% month-over-month change. Employment is due on July 5 and CPI on July 11.

Other key market levels:

  • Fed RRP balances closed Friday at $665 billion, up an extraordinary $134 billion in one day and $243 billion in one week. RRP balances have bounced between $400 billion and $500 billion since the start of March but balances this week have broken that range. With the end of the second quarter coming on Sunday, it looks like private portfolios have slashed demand for repo financing and forced money funds to move cash to the RRP. Overnight GC rates for Treasury repo have dropped 12 bp in the last two days, to that suggests a drop in demand as well.
  • Setting on 3-month term SOFR closed Friday at 532 bp, down 2 bp in the last week.
  • Further out the curve, the 2-year note closed Friday near 4.75%, up 2 bp in the last week. The 10-year note closed at 4.40%, up 15 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -35, steeper by 12 bp in the last week. The 5s30s closed Friday at 18 bp, steeper by 5 bp over the same period
  • Breakeven 10-year inflation traded Friday at 229 bp, up 6 bp in the last week. The 10-year real rate finished the week at 211 bp, up 9 bp in the last week.

The view in spreads

Implied rate volatility has bounced higher lately but stayed near the low end of its range this year, putting temporary pressure on risk asset spreads. Credit still has the most momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 94 bp, unchanged in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 149 bp, 6 bp wider on the week. Par 30-year MBS TOAS closed Friday at 41 bp, wider by 9 bp in the last week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also 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, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies, that that has as much to do with the price of used cars as it does the consumer balance sheet. 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. US banks nevertheless have a benign view of credit in syndicated loans. 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
steven.abrahams@santander.us
1 (646) 776-7864

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