The last few days have seen some stresses in the bond and funding markets. The charts below illustrate a few of these, we then detail why the Fed intervened and cut again. The stresses are coming at a time when markets are fearful of the size of the sudden stop in economic activity we are witnessing due to actions being taken to defeat the coronavirus pandemic. Some sections of the economy are seeing large and fast drops in revenues, with a double whammy hit to the oil patch driven by the Saudi/Russia/OPEC actions in the oil price. Businesses are beginning to draw on revolving lines of credit in order to weather the storm. Markets are dropping, also contributing to the disruptions as positions are unwound into illiquid markets. At times like these, disruptions can be seen in different places.
FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread.
Commercial Paper markets began to show signs of strain. This is a lifeblood market that companies use to borrow short term and fund everyday expenses at terms of under a year. Having rates increase and access to funding drop at a crucial time is a clear threat to the ability of the real economy to weather a storm. Given the impact of states shutting down for short periods, companies need to be able to borrow to cover real economic weakness.
On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y points for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. Late last week, they began to move apart. An example below – the green/red column shows a Z-Score of individual bond spreads of similar maturities roughly 10 years out.
Source: Bloomberg, 3/16/2020
Cross currency swap rates. The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis.
LIBOR spreads measures the spreads in different maturities of LIBOR rates. These can shift with expectations of upcoming monetary policy action, but generally speaking need to be kept orderly for markets to function well. As the market expected and wanted a cut to zero, rates moved considerably, this arguably called for the Fed to pull forward its planned cut. Below is overnight vs 1 month.
The Fed delivered a second inter-meeting cut on Sunday in response to the coronavirus and to try and alleviate these funding stresses to allow better transmission of monetary policy. The FOMC lowered the federal funds rate by 100bps to a target range of 0 to 0.25 percent, as well as providing forward guidance, noting that they expect “to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
Alongside this, the FOMC announced a program to purchase assets of $700bn, split $500bn in Treasury securities and $200bn in agency mortgage backed securities. The statement spoke of wanting to ‘support smooth market functioning’. These purchases began yesterday. Note that in QE3 the peak pace was some $85bn per month. Make no mistake – these purchases are huge. The FOMC also made a plethora of changes to other parts of the plumbing aimed at improving the efficacy of market plumbing and conducting policy, including lowering the discount window spread, reducing the rates on OIS on swaps with foreign central banks and eliminated reserve requirements. Today they have announced the establishment of a Commercial Paper Funding Facility.
The Feds goal here is to implement monetary policy – where stresses arise they will try and squash them. The capital ratios that are binding – reduced. Discount window stigma – gone. Overseas dollar costs going up – swap lines. Mortgages rates up a little – $200bn of MBS purchases. Treasury curve on-the-run/off-the-run blowing out – $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. Did it work? Well it is early, but so far it looks like some of these have eased. They are worth keeping an eye on. By way of example, the easiest one to keep an eye on updated through todays close. FRA-OIS dropped a lot today.