We love it when writers connect the dots. On the blog “The Big Picture” a Dec, 5, 2012 post by James Blanco does just that, connecting General Collateral Repo rates, the Volcker Rule, Quantitative Easing, and the Fiscal Cliff together.
“The Big Picture” is economist Barry Ritholtz’s blog and it is always worth reading. James Blanco’s post starts by citing an interview with Paul Volcker, who said that banks were already acting as if the Volcker Rule was in place; cutting back on their proprietary trading activity.
Blanco makes a number of points:
- Evidence of dealers pulling back from prop trading is found in the UST GC rates, which are trading above Fed Funds
- This rate relationship is odd since GC is secured, Fed Funds are not and one would expect the opposite to happen
- Capital and leverage constraints prevent the dealers from arb’ing this relationship back into place
- The Fed Funds rate is distorted as well, with the GSEs the only participants
- None of these market structural changes are very new, so it makes sense to look for at new factor: the fiscal cliff
- Blanco says that if the US goes off the cliff, and Moody’s downgrades the Treasury, then investment funds who are limited to only repo’ing debt with at least one AAA rating won’t be able to take UST debt as collateral for their cash investments
- Evidence for lack of dealer interest in shorting paper was the low level of borrowing UST paper from the Fed’s securities lending facility
Put this all together and the market is getting less liquid and more inefficient. Absolutely true.
There are couple things we would question. Parts of the tri-party repo market typically trade above Fed Funds and have for years, despite being secured by collateral. Theoretically, any collateralized exposure is better than an unsecured loan and hence tri-party should be below Fed Funds. Not so. It has always been a mystery to us, but blame it on frictional costs, bank Treasury departments’ constraints on funding their dealer divisions unsecured, and overall complexity.
Blanco’s comments on the Fed Funds markets left out IOER. By the Fed paying 25bp on excess reserves, there is little reason to be active in the market — just ship it all to the Fed. The only people left involved are the GSEs, who are captive. We wrote about that on December 3rd in our post “Fed continues to believe in IOER as-is; we think it is time for a serious policy review”.
While the dealers might be pulling back on prop trading, can’t hedge funds and tons of other market participants short to their heart’s content? It is possible that fixed income hedge funds and others have de-risked (or simply don’t see a need to hedge long positions) but this could be temporary.
Year-end statement pressure was one reason not brought up in the blog post. This impacts all market participants as they seek to tone down their balance sheets and/or protect their P&L. Seasonality comes in all sizes and shapes and should never be underestimated.
Blanco connected the fiscal cliff to reluctance to invest in repo. But that seems to be a forward looking argument on a market that is not forward looking. Since repos are usually very short term deals, and the rating constraint only kicks in when it actually happens, why would investor behavior necessarily change before the fact? We are skeptical that there are many repo investors who are currently active in UST repo and who have not already prepared if Moody’s downgrades too. On the other hand, when S&P downgraded the US, nothing much changed despite warnings of nearly apocalyptic proportions. But surely the S&P downgrade made investors consider that another rating agency doing the same thing was a distinct possibility and got their Plan B ready? Maybe investors who own outright UST paper are thinking twice, but on repo….not yet.
We think about QE and how the Fed has shifted the maturity of their balance sheet in Operation Twist. The shorter paper has to go somewhere and could be clogging up bank balance sheets. The technical distortion created by the overhang of short paper (and not enough investors buying it – perhaps they are feeling more comfortable about markets and don’t crave short “safe” paper like they used to) feels like it is an unintended consequence of Twist combined with positive market sentiment.
As far as the Federal Reserve’s securities lending program and its utilization, it is interesting and might have some information content, but it is hard to make much of it. That program is designed as a lender of last resort, typically tapped when there are settlement or other technical problems. Dealers collateralize their bond borrowings from the Fed with General Collateral, making it a zero sum game. Blow up the chart and you realize the actual amounts borrowed are not material compared to the size of the UST market.
We applaud anyone who looks at these markets holistically. Any reader of this blog knows we pay particular attention to repo. The influence of repo, despite being a critical lubricant of the securities markets, often gets left off the list of factors that move markets. At the end of the day, we are not sure that all of Blanco’s dots can be connected, but it raises the level of discussion and that is good news.
A link to the Big Picture post is here.
A link to the Dec. 3, 2012 SFM post on IOER is here.