- This time it's different
- Economic Vista: How much “insurance” is enough?
- Credit Vista: On solid ground
- Trading Vista: Waves in the repo market
Jose Sevilla, Senior Portfolio Manager
Last month’s dislocations in the overnight repurchase agreement (repo) market have caught the attention of many, grabbing numerous headlines throughout September. While it’s important to note this was not a result of any credit concerns like in 2008, but rather was driven by supply and demand dynamics, it is also important to examine the events that led to this, primarily given the fact that excess reserves have diminished in recent years. So what exactly happened that brought this usually steady market into the financial news headlines?
On September 16, the overnight repo market — where yields closely track the federal funds rate, which is currently in a range of 1.75 to 2.0 percent — started experiencing a sudden demand shortage, thereby causing overnight repo yields to jump as high as 10 percent intraday. The spike has been attributed to a confluence of factors, all of which combined to pull excess cash from the market.
First, many US corporations had drawn down balances to make their quarterly Federal tax payments. In addition to this, close to $80 billion of newly issued Treasuries settled on the same day and required financing on dealer balance sheets. These circumstances caused an imbalance in the supply and demand for short-term cash, thereby causing repo rates to immediately move higher. In an effort to bring the overnight rates back within the fed funds target range, the New York Fed stepped in by injecting $75 billion of liquidity into the markets via their own repo facility, and in the following days, they increased the size of their repo operations to maintain short-term lending rates within their target range.
It’s also important to step back and look at the broader events that led to this. One contributing factor is the size of the Fed’s balance sheet. The Federal Reserve purchased an unusually high number of bonds during their quantitative easing (QE) cycle, which lasted from November 2008 to October 2014, draining collateral and creating excess reserves in the banking sector. But as the central bank pared back its balance sheet from 2017 to August 2019, it left commercial banks with a smaller pool of excess reserves. This smaller pool, combined with a regulatory need to retain more on-balance sheet cash (i.e. Basel III capital requirements and higher liquidity coverage ratios), has exacerbated some of the liquidity challenges in the market. Banks are now more limited in their ability to easily step-in and lend cash in the short-term funding markets.
What can be done to ensure stability in the overnight funding market and to avoid these types of disruptions from occurring again? One proposed solution is for the Fed to implement a Standing Repo Facility. This essentially is a systematic way for the Fed to lend cash to banks in return for high-quality securities as collateral, thus providing stability and expectations around how much liquidity the Fed will be injecting into the system. However, at the September Federal Open Market Committee (FOMC) meeting where the Fed cut the fed funds rate for the second time this year, the Fed made no imminent decision on whether it would implement such a facility.
Another measure the Fed is considering is engaging in additional open market operations such as increased asset purchases. At his post-September FOMC press conference, Chairman Jerome Powell said, “it’s certainly possible that we’ll need to resume the organic growth of the balance sheet earlier than we thought.” Rather than being another quantitative easing (QE) tactic, this would be part of normal Fed interaction to ensure proper functioning of short-term interest rates.
At this point though, the Fed has undertaken a number of “temporary repo transactions” to establish sufficient excess reserves and to maintain repo rates within the fed funds target range of 1.75 to 2.0 percent. These operations have stabilized the market in the short-term, while longer-term solutions continue to be worked through. And although this time is indeed different from a credit perspective, we will continue to prudently monitor the repo market.
The Federal Reserve gave the US economy another slug of “insurance” in September, but is that the end of the line? As widely expected, the FOMC cut the federal funds target range for a second consecutive session by 25 basis points (bps) to a range of 1.75 to 2.00 percent. Although the FOMC left the door open for future rate cuts, its statement had a hawkish tilt, emphasizing that any future rate moves will be dependent on the economic data as well as trade negotiations and the outlook for global economic growth. For now, however, there is no preset course to monetary policy.
The data releases as of the end of September illustrates just how resilient the US economy has been, despite various headwinds. The labor market, for example, continues to add jobs, albeit at a slower pace in recent months. Last month the US economy added 130,000 jobs, missing expectations by 30,000. The three- and six-month moving averages have been trending lower since the beginning of the year and are currently at 156,000 and 150,000, respectively. Meanwhile, the unemployment rate remained unchanged at 3.7 percent, the labor participation rate ticked up slightly to 63.2 percent and wage growth remained steady at 3.2 percent.
Recently, there’s been more focus on business confidence, given the potential impact of trade policy. The Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI), which tracks the sentiment among various purchasing managers, has been trending lower since the beginning of the year. The September release reading of 49.1 was the lowest in more than three years and somewhat concerning as any sub-50 reading indicates contraction in the manufacturing sector. In contrast to this slowdown, the services sector, which is the biggest component of the US economy, continues to expand, however, at a slower pace. The September reading of 52.6 was a decrease over the prior month and below expectations.
Advance estimates for US retail sales beat expectations and rose 0.4 percent in August, while the prior month was revised slightly upward to an increase of 0.8 percent. Despite ongoing trade tensions, the US consumer continues to spend, perhaps reflecting underlying confidence in the job market. Retail sales were fueled by spending on autos and online shopping, while restaurant spending decelerated from a robust pace.
Inflation continues to be muted; the Fed’s preferred measure is currently at 1.8 percent, which is below the Fed’s preferred 2.0 percent target and leaves room for further easing. However, the core Consumer Price Index (CPI), which excludes volatile food and energy prices, rose to 2.4 percent annually and has been trending higher since May. The latest increase reflects tariffs on products, such as computers, as well as higher costs for airline tickets, recreational services and tobacco products. When including more volatile components, headline CPI increased only 0.1 percent on a month-over-month basis and 1.7 percent year-over-year.
Housing was yet another resilient sector. Thanks largely to lower interest rates, housing starts jumped in August to a seasonally adjusted annual rate of 1.364 million which is an increase of more than 12 percent over July and the highest rate in more than a decade. Existing home sales also beat expectations at an annual rate of 5.49 million units, and new home sales increased to 713,000 in August, which is a 7.1 percent increase over the previous month.
Looking ahead, all eyes will be on incoming economic data and trade negotiations, as the market tries to anticipate the Fed’s next move. A key input for that decision, of course, will be GDP. Real GDP increased at an annual rate of 2.0 percent in the second quarter of 2019, according to the most recent release from the Bureau of Economic Analysis (BEA). This is largely in line with expectations and reflects, among other factors, the strong labor market and robust personal consumption at an 18-month high.
Tim Lee, CFA, Senior Credit Risk & Research Officer
A quick analysis of default rates suggests that debt investors have few reasons to fret, as corporate borrowers continue to pay their debt investors as promised. Through August 2019, the rate of issuers around the world that are current on their bond and loan obligations was close to 99 percent, according to data from Moody’s Investor Services. Among the universe of issuers that Moody’s rates, the trailing 12-month default rate stood at a mere 1.1 percent, with the default rate of all US corporate issuers only nominally higher at 1.7 percent. This year’s default rate is lower than a year ago, when the trailing 12-month global default rate was 1.5 percent and 2.1 percent for US issuers.
Year-to-date, Moody’s has counted 56 issuers that have defaulted, compared to 57 for the same period in 2018. Similar to last year, energy and retail are the two sectors with the higher number of default issuers, as oil and gas prices remain far below their peak levels and the retail sector continues to face structural shifts in consumer shopping habits and discretionary spending preferences. All of the issuers that have defaulted this year sported speculative grade Moody’s ratings, with one exception: Northern California utility Pacific Gas & Electric (PG&E) and its PG&E parent, which filed for bankruptcy in January, had an investment grade rating in late November 2018, before it succumbed to extreme weather-related liabilities.
Outside of the idiosyncratic situation that felled PG&E, all other issuers rated as investment grade by Moody’s have been current on their debt obligations this year. Looking ahead, Moody’s is forecasting a 3.3 percent global default rate through August 2020 across its ratings universe, with a zero percent default rate for investment grade issuers, except for those in the Baa category, where Moody’s predicts 0.1 percent of issuers to default. While a plethora of political and economic issues could drag down corporate credit quality over the next year, it is worth noting that investment grade issuers have traditionally been well armed to fight off default. For starters, the historical average one-year default rate for lower investment grade rated bond issuers (those in the A3, Baa1, Baa2 or Baa3 categories) is 0.16 percent, and for medium investment grade rated bond issuers (those in the Aa3, A1 or A2 categories), that same rate is 0.07 percent. Put another way, 99.8 percent of investment grade issuers, on average, were still paying their bond investors a year later. All of this illustrates that the investment grade debt markets are on solid footing, and that should assuage any investor fears that slowing global growth or trade turmoil will trickle down to negatively affect the credit environment in the near term.
Hiroshi Ikemoto, Fixed Income Trader
After going more than 10 years without a rate cut, the Federal Reserve lowered its target rate by 25 basis points (bps) for the second time in as many meetings. Although the markets had priced in this 25-bps cut for some time, the “hawkish cut” triggered a slight backup in Treasury rates. Based on Fed comments, investors seemed less sure if there would be another cut this year. Currently, the Fed Funds Implied Probabilities shows a 75 percent chance of one additional cut in 2019, even as the Fed insists any future moves will be data dependent. With mixed economic data and geopolitical issues constantly making headlines, it’s no surprise that Treasury markets have remained relatively volatile. The 2-year benchmark note has traded from a yield low of 1.43 percent on September 4, 2019, to a high of 1.80 percent just a short 11 days later. That sort of range is uncommon in such a short period.
However, that volatility was not even the most significant market news. This month we witnessed a huge spike in yields for repurchase agreements (repo) that occurred mid-month. The money markets usually see a jump in rates at month-, quarter- and year-end – a time when there are less funds in the repo world due to firms keeping cash on their books, so this spike intra-month caught many investors off guard. It was curious, to say the least, that the market was unable to correct itself like it usually does but is further explained above. The disconnect was so acute that the New York Fed had to step in to provide liquidity into the market for the remainder of the month, which in turn stabilized rates. Since we are on the reverse side of these transactions, meaning we are investors or liquidity providers to the market, we were the beneficiary of these elevated rates while they lasted.
The corporate bond market was insulated from the repo noise, as flows were normal and spreads remained unchanged month-over-month. All-in yields, however, were fluctuating, as Treasury yields bounced around throughout the month. The commercial paper market saw rates tighten as 3-month London Interbank Offered Rate (LIBOR) decreased by four bps month-over-month.
With the market still pricing in one more Fed rate cut this year, we continue to maintain our strategy of keeping the average duration of our portfolio neutral-to-longer than our targeted benchmarks. We also continue to remain disciplined. We are emphasizing the duality of providing portfolio liquidity by investing in high-quality issuers and keeping an allocation in overnight investments to provide flexibility, while purchasing longer bonds to lock in yields in an ever-changing rate environment.
|Treasury Rates:||Total Returns:|
|3-Month||1.81%||ML 3-Month Treasury||0.19%|
|6-Month||1.81%||ML 6-Month Treasury||0.19%|
|1-Year||1.75%||ML 12-Month Treasury||0.15%|
Source: Bloomberg, Silicon Valley Bank as of 9/30/19