The rout in the fixed income markets may have been triggered by the Fed talking tapering, but it was made worse by quarter-end pressures on repo balance sheets and lack of bank prop desks.
We have written before about our expectation that without prop desks in banks (thanks to early positioning for the Volcker Rule) the liquidity was going to come from hedge funds. And those hedge funds were going to turn around and fund positions with the bank repo desks. Well, to the extent this is happening already it is taking the place of the previous model of bank desks picking up the slack and taking advantage of liquidity needs. In short, volatility in the fixed income has arrived.
Market turns are always gut wrenching, but we wonder if the reaction to the Fed has been exaggerated by the absence of bank prop desks to absorb the selling and trade around positions.
We have also just passed quarter end. Cash dealers come under pressure to minimize balance sheet usage, resulting in stepping back from markets. But the biggest impact of statement dates is on financing books. Some banks nearly shut down their financing operations over statement dates, leaving their clients out in the cold. This has been increasing more as banks look not to end of quarter dates but also end of month. In some cases they are averaging their exposures over a month creating even more structural reductions in balances. The combination of no prop desks to absorb paper plus repo desks shrinking results in the market clearing at lower prices. Some financing desks can work their balance sheet netting magic to keep the taps open, but that too has its limitations.
It will be interesting to see what happens now that quarter end has passed.