The Big Idea
A healthy market for risk
This material is a Marketing Communication and does not constitute Independent Investment Research.
US investors’ ability to trade in and out of risk and get enough financial leverage to exploit relative value looks as healthy in this market as it has since the Fed started tightening in 2022. Trade volumes look strong and funding markets look well supplied with cash. That should keep risk fairly priced and the odds of dislocation remote.
Trading volumes across most assets, adjusting for rising outstanding amounts, have been flat or going up since late 2022 (Exhibit 1). Trading in the Treasury market has bounced around 5.7% of outstanding amounts since 2022. Trading in MBS has trended from around 4.4% to around 6.0%. And trading in investment grade corporate debt has trended from around 1.9% to around 2.2%. Investors are able to move in and out of a steady-to-rising share of each market on any average day.
Exhibit 1: Trading volume as a share of outstandings edges up since 2022
Note: Data shows NY Fed primary dealer average daily trading volume as a share of outstanding par balance of the Bloomberg Treasury, corporate and MBS index. Trading volume is the 4-week average at the end of each month, index value is the par balance at the end of each month. Source: NY Fed, Bloomberg, Santander US Capital Markets.
Markets in general also are working with a heavy supply of cash, with balances at money market mutual funds just below a record $7.95 trillion. Cash from money funds along with bank reserves—on the rise since last December and helped by the end of the Wells Fargo asset cap—have made the repo market very accommodating. The signs of that:
- SOFR is generally running below interest on reserve balances (IORB), suggesting that cash from outside the banking system—such as from Fannie Mae and Freddie Mac—is dragging funding rates below the return on bank reserves (Exhibit 2)
Exhibit 2: SOFR lately trades below IORB, a sign of easy funding
Source: Bloomberg, Santander US Capital Markets
- Tri-party repo volume continues to run around $2.3 trillion a day, but the volume of trades with 30-day or longer maturities continues to climb, a sign of improving risk appetite from portfolios providing repo cash (Exhibit 3).
Exhibit 3: Steady tri-party volume, but rising volume of term repo trades
Source: BNY, Bloomberg, Santander US Capital Markets
- Repo haircuts in June matched their 1-year average in most assets but fell slightly below average in agency CMOs and non-investment grade corporate debt, a sign of steady-to-marginally better financial leverage (Exhibit 4)
Exhibit 4: Repo haircuts are at or below their 1-year average
Source: New York Fed, Santander US Capital Markets
The combination of steady trading volume and ample cash available for repo should help police any market price discrepancies, and the Treasury market offers a clear example. As measured by the relatively low dispersion between on- and off-the-run Treasury yields, for instance, the market is as liquid and efficient as it has been since 2022 (Exhibit 5).
Exhibit 5: Steady trading, easy financing narrows UST yield dispersion
Source: Bloomberg, Santander US Capital Markets
Fluid trading volumes and ample but disciplined financing make for healthy markets. Investors can feel more confident in their ability to get in or out of risk as market fundamentals, supply and demand or portfolio needs change. Leverage helps correct mispricings. Given current conditions, these things should keep risk fairly priced across debt assets and limit the odds of sharp discontinuities in rates or spreads.
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The view in rates
The market for now is pricing 32 bp of Fed tightening by the end of 2026 with very little through 2027. The very front end of the curve is probably stuck at a floor of 4.00% or higher through 2026 depending on US-Iran and expected short-term inflation. The 10-year note continues to look like it will spend more time above 4.40% than below it for the balance of the year. A lasting and stable agreement between the US and Iran could take 10-year yields reliably below 4.40%.
Key market levels:
- Setting on 3-month term SOFR traded Friday at 373 bp
- Further out the curve, the 2-year note traded Friday at 4.18. The 10-year note traded at 4.55%.
- The Treasury yield curve traded Friday with 2s10s at 37 bp, steeper by 2 bp in the last week, and with 5s30s at 79 bp, steeper by 3 bp
- Breakeven 10-year inflation traded Friday at 225 bp with 5-year forward 5-year breakeven at 220 bp, up 1 bp in the last week, still signaling confidence that the Fed target still holds. The 10-year real rate finished the week at 230 bp, unchanged on the week.
The view in spreads
The supply and demand balance looks neutral-to-negative for MBS, neutral for corporate debt and particularly weak for technology debt. MBS net supply continues to run very low, but the expected steady bid from Fannie Mae and Freddie Mac has not materialized. Insurers continue to issue annuities and buy corporate and structured credit, but credit is facing significant needs to finance capital investment and the current AI buildout. MBS spreads look a little soft, most credit should continue slowly tightening and technology spreads look likely to lag both.
The Bloomberg US investment grade corporate bond index OAS traded on Friday at 76 bp, wider by 1 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 110 bp, out by 2 bp on the week. Par 30-year MBS TOAS closed Friday at 23 bp, wider by 3 bp on the week.
The view in credit
Big companies have healthier balance sheets than smaller companies. Consumers at the middle-to-higher end of the income distribution also have low debt burdens, liquidity and wealth. Bank lending to non-bank financial institutions, including private debt funds and business development companies continues to expand. Bank regulators continue to focus on that category of lending, which could eventually tighten the private credit markets. But for now, credit metrics for NBFI lending are strong relative to traditional bank lending such as C&I.
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