Stresses In The Bond and Funding Markets: Post Mortem

We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.

The first is from the NY Fed Liberty Street Economics blog and details the Feds Large-Scale Repo program.

The second is in the Financial Times (paywall) and details the moves we witnessed in the US Treasury markets:

The third is from Josh Younger of J.P. Morgan writing for the Council on Foreign Relations:

All succinct and detailed pieces that will explain a lot of what went on.

 

 

Stresses In The Bond and Funding Markets: Update 2.0

We are now a couple of weeks on from the last update we wrote looking at the actions the Fed had taken to stabilize bond and funding markets. Given last Thursday began with further announcements of expanding efforts to help, it seems a good time to revisit where things stand now. The commercial paper program is now up and running and we should be seeing the first of the “Economic Impact Payments” hitting household accounts right around now.

First, a recap of the most recent actions. April 9th saw the Fed announce actions to provide up to $2.3 trillion in loans to support the economy. They are doing this in a few ways, financing the loans banks are making to small businesses under the Paycheck Protection Program. This is the program that gives small businesses a direct incentive to keep workers on the payroll, via loan forgiveness if all employees are kept on the payroll for 8 weeks post the first disbursal. Coupled with the expanded Unemployment Insurance benefits, the goal is to minimize the income shock as much as possible to workers by either increased benefits to laid off workers or aiding companies in paying wages to keep people employed through this period.

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. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update2

Source: Bloomberg

The Fed’s Commercial Paper Funding Facility became operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. This space took a while longer to show signs of healing, and has a ways to go still, but some positive signs in the rates below.

CommercialPaper update2

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point 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. At the height of the bond market dislocations, they began to move apart. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update2

Source: Bloomberg

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. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia amongst others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update2

Source: Bloomberg

Credit spreads moved out aggressively in March. The Fed actions to launch two credit facilities backing corporate credit markets, a Primary Market Corporate Credit Facility for new bond and loan issuances and a Secondary Market Corporate Credit Facility to provide liquidity for outstanding corporate bonds has so far worked to narrow spreads and calm nerves.

creditspreads update2

Source: Bloomberg

At pixel time for the last update the Fed was rolling out a plan to lend as much as $500 billion to states and local government to aid them through this period. Spreads continue to stabilize here, and we are starting to see a return to issuance, with about double the number of offerings the next couple of days than last week.

Munis update2

Source: Bloomberg

One other area to keep an eye on as it pertains to credit availability, and also as it acts as something of an accelerant to activity. Mortgage spreads. These have moved wider on credit concerns, plumbing problems with mortgage buyers and refi demand. Part of the goal of lowering rates is to allow for widespread refinancing of mortgages and lower rates to grease the wheels of housing more generally. The more mortgage rates can track government rates down to new lows, the better. The chart below shows the difference between the Bankrate 30Y Mortgage National Average Rate and the US Ten Year Government bond.

mortgagespreads update2

Source: Bloomberg

So what to make of all these actions? Well first, time to update some priors. Even though rates were low, the Fed had room to act. Is it out of room now? We doubt it. If one has learned anything it is that a newly minted, awfully acronym-ed, facility can spring up and get funded fairly quickly. But don’t take our word for it – Fed Chair Powell literally went on the Today Show and told us – ‘We’re not going to run out of ammunition’. It is also worth noting that it is easier politically for programs to be extended in time and buying power now that they are here than it is to get them over the finish line first time round. To our eye, the policy actions from both the Fed and Congress are like using a pole to cross a ravine. It doesn’t matter how deep the ravine is, scary as it is to look down, it matters how wide it is. The real economy beginning to open up in the next couple of months will be welcome relief for all – many more quarters like this and the Fed and Congress will have to go back to the drawing board.

 

 

Stresses In The Bond and Funding Markets: Update

We wanted to post an update to our previous entry on Stresses in the Bond and Funding Markets and the Fed response. Over the last few days we have seen substantial easing in some of these markets as central bank actions have begun to filter through. Not all markets see the plumbing impacts immediately, as it can take some time for money to reach the target. Payments have to settle, loans extended, bond market programs fired up with funding and the like. The charts below are the same ones we showed before, in the eye of the storm (or at least we hope that was the eye).

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. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update

Source: Bloomberg

Commercial Paper markets continue to be wide. The Feds Commercial Paper Funding Facility becomes operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. Watch this space.

CommercialPaper update

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point 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. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update

Source: Bloomberg

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. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia among others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update

Source: Bloomberg

LIBOR spreadsmeasure 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. The Fed cut for second time on Sunday March 15th (and then cancelled the regular March meeting).

LiborSpreads update

Source: Bloomberg

The Fed’s 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 one-the-run/off-the-run blowing out, $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. At times like these one starts to hear that the Fed must now be out of bullets. Rates are zero after all and what more can they do? Well people have said this for a while and here we are. The Fed is immensely powerful in dealing with this type of event, and clearly this time has acted very quickly and in particularly large size. As we write, another story comes up highlighting the impact on a different area where the Fed is now active, in corporate bonds. AAA CLO spreads have halved in two days. Municipal bond spreads were another area shifting out. The chart below shows the AAA muni yield as a percentage of the same duration US Treasury (relevant due to the different tax implications). So what did the Fed do – squashed it.

Munis update

Source: Bloomberg

Stresses In The Bond and Funding Markets

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.

FRA-OIS

Source: Bloomberg

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.

CommercialPaper

Source: Bloomberg

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.

OffTheRun

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.

CrossCurrencySwaps

Source: Bloomberg

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.

LiborSpreads

Source: Bloomberg

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.

FRA-OIS v2

Source: Bloomberg

Recessions Everywhere

It is likely the depth and severity of the 2008/09 crisis are contributing, through something akin to PTSD, to the deafening drumbeat of recession calls. The interviews out of the WEF in Davos are almost unanimous that a recession is coming in the next 18 months or so. David Solomon, the new Chairman and CEO of Goldman Sachs put the odds at 50% for 2020. It is by now certainly the consensus view, and judging by the interest rates curve, it is in market prices. We think this has gone a ways too far. Sure, there are paths that lead to that outcome, it is perfectly possible. But 50%? Or a base case from here? We think that’s a stretch.

endisnigh

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Convex Tails

US yields have clearly shifted over the past 6 months or so. The move is justified – stronger global growth, a large fiscal package and a pickup in inflation. At this juncture, where do things stand? Interest rate futures are still pricing a hiking cycle a ways under the Fed projections. There’s about 100bps priced between here and December 2019. Not a high bar – we could reasonably have that this year, hiking once per quarter. To our eye, the measured and linear pace priced by markets is going to have to contend with economic activity that may be decidedly nonlinear. We just don’t know what happens when you slash corporate and personal taxes at very low levels of unemployment, pour on an infrastructure package at the same time, and see a pickup in global growth. Are retail sales linear when every paycheck in the country gets a big boost? Are capex plans linear when corporate taxes get markedly reduced and regulatory burdens reverse? Are wages linear at 4.1% unemployment? Is the impact of a reduced Fed balance sheet – particularly in mortgages – and an ECB that’s edging toward the door linear on term premium? How about corporate holdings of bonds under a new and drastically different tax regime? Or are these things convex? We may find out soon. It didn’t make sense that interest rate volatility was so low – it is all about the convex tails.

convextail

FOMC member interest rate projections and market pricing implied interest rate path.      SOURCE: Bloomberg

Markets Change and Shift…Issue 78

The chart below shows the 3 prices series – the US 5 year yield, the US Dollar-Japanese Yen exchange rate and the price of gold – inverted here. Each of these markets have their own fundamental drivers, but for periods of time they can share the same set of dominant factors that determine price action. A story gets built around them that sounds compelling, and correlations become self-fulfilling…for a while. In previous years, these markets have been a popular way to trade interest rate views, but the recent divergence is fascinating. It’s a good example on the importance of focusing on the areas closest to home when taking macro bets, rather than being lulled into related markets that may be correlated at the time. If those correlations change, you can be right on the view, but wrong in the implementation. That’s no fun for anyone.

The narrative around each is decently intuitive – if you thought yields would go up, positioning in the currency markets where interest rate differentials are often dominant drivers makes sense. Nowhere is this more true than in Yen, which has arguably the most extreme form of easing in yield curve control, pegging the 10 year JGB around zero. Further, Japan appears to be the furthest major economy from tightening. This made sense for a while – as you can see in the run up to the US election and the reactions afterwards, perfectly fine way to play it. The gold view was also fairly compelling – low rates would lead to inflation, which gold is a great hedge against (not that we agree, but that was the view). So higher rates, particularly real rates, would push gold down. Again, in the run up to, and coming out of the election, this was an OK way to position. Spreading risk between the three expressions was a defensible thing to do. The second chart drums it home a different way – it shows just USDJPY and the US 5 year yield, and the 30 day correlation. That’s likely too short a window, and correlations are odd things, but it gets the point across – they correlated at 0.8 during these periods.

The recent move higher though…not so much. Gold has not fallen, and the Japanese Yen has gone the opposite way. Only the rates view worked. That 0.8 correlation went to zero on a dime. New narratives are popping up to rationalize it away and sound smart ex post – but ex ante it wasn’t clear at all. No one knows if it will continue or will revert either. Markets change and stories shift – the more things change, the more they stay the same.

rgy1

Source: Bloomberg

rgy2

Source: Bloomberg

Why Financial Conditions Are Easing…

Two years ago, Dudley was spooked by tightening financial conditions.  Now, they can’t figure out why they are so loose.

I think there is a simple explanation.  Two years ago rates were so low that credit could not go any lower, as they would go below the default rate.  So it looked like financial conditions tightened.  Now, as the fed raises rates, credit has stayed at the same price, so it looks like financial conditions are getting looser.  Here is a chart of auto loans.  Rate has not changed.  Unless the central banks buys credit (as they have done in Europe, forcing HY below UST), the nominal rate cannot go any lower, but won’t go up right away either. If you are at the default bond in credit, do measures of financial conditions fail to make sense?

Despite three Fed hikes over the past year, the rates on new-vehicle loans remain near multi-decade lows.

source: https://fred.stlouisfed.org/series/RIFLPBCIANM60NM#0

To a Man With a Hammer, Everything Looks Like a Nail

This FT piece by Gavyn Davies is getting some attention. He makes the case that the upturn in growth we are currently seeing is likely not a secular shift from possible stagnation, but a (welcome) cyclical burst. He references San Francisco Fed President Williams recent paper concluding that the equilibrium real interest rate (r*) is likely to remain much lower than in the past. Briefly, r* is derived by reflecting on an ex post realized output gap relative to the Feds policy stance. If the Fed sets policy rates at what they think ex ante are very accommodative real interest rates relative to the estimate of neutral rates at that time, and yet over the forecast horizon growth doesn’t respond, they conclude that they haven’t been as easy as they thought. They then mark down what the neutral rate must have been, and then judge their current policy stance in relation to the new neutral rate. The effect of this is that in the Feds mind, policy rates at 0.5% could go from being thought of as very easy, to not that easy, if growth didn’t respond.  Even though the principal author of secular stagnation Larry Summers is clear that it is a hypothesis, this is lost on the commentariat who treat it as a gospel fact that we are doomed to live out as Japan for the medium to long term.

But is It true? Is it relevant for the future? How much weight should one put on the whole premise? To our eye it’s an exercise in false precision. These are the issues as we see them.

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Stability…or a Coiled Spring?

piggybankA while back I read a piece about political stability not being all it seems. It made the case that looks can be deceiving, and illustrated it something like this. Since 1945 Italy has had some 40 changes of prime minister. Saudi Arabia has had 6 rulers in the same period. North Korea has had 3. By that metric, Italy appears pretty unstable, while the other two look like oases of calm. But which keeps you up at night? For all the Machiavellian twists and turns in Italian politics, the political process has a way to reset the compression of the spring, to take out some of the tension every few years to stop it from popping, as the Italians turf out the incumbent and vote for a change. North Korea and Saudi Arabia on the other hand don’t have the mechanism, and need more and more pressure to keep it in place. The force underneath keeps on building though, the eventual reaction getting bigger. But that’s statistics for you – measured that way you get an answer on stability, but it’s probably the wrong one.

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