Updates From the Fixed Income Desk

U.S. Fixed Income

2011 has been a volatile year for all markets with U.S. Fixed Income being no exception.  The quarter started with the Federal Reserve’s Operation Twists on October 3. The remainder of the quarter was consumed by the ongoing European debt crisis – each day seemed to bring new market-moving developments and had markets on edge.  Investor concerns about Europe spilled over into the U.S. Fixed Income markets in a number of ways.  Investor risk aversion caused bond yields to soar to record highs for some Eurozone countries and conversely Treasury yields dropped to record lows. Moreover, the market focused on banks and other financial institutions with outstanding European debt exposures.

As with previous quarters-end/years-end, dealers had very limited balance sheets in December to bid for collateral over the “turn” (December 30-January 3).  As a result, dealer bids for new trades over the “turn” were significantly higher than normal – with at least a 10 basis point premium attached to bids. On the last day of the year, Fed Funds opened at 0.04 with Treasuries trading at 0.06%, Agencies, 0.10% and Agency MBS, 0.12%. Late in the day, a shortage of Treasuries sent rates sharply lower as general collateral traded at a negative rebate rate as dealers scrambled to secure Treasuries the last day of the year. 

Looking ahead, 2012 is shaping up to be another challenging year for fixed income lending markets as the Federal Reserve announced their intention to hold rates steady until 2014.  Furthermore, J.P. Morgan’s strategists now assign a high probability of additional balance sheet expansion and enhanced Federal Reserve communications by providing guidance that is forward looking.  As J.P. Morgan noted in their recent U.S. Fixed Income Markets 2012 Outlook: 

“Presumably, the aims of QE-MBS would be two-fold. First, as with QE with Treasuries, QE with MBS would remove duration from the marketplace, putting downward pressure on all long-term interest rates. Second, QE-MBS would specifically put downward pressure on mortgage rates by compressing spreads. If these lower rates in the secondary market were passed on to primary mortgage rates, it would have the added benefit of supporting the housing market.”

“Enhancing communications by providing more forward guidance does not create the same buzz among market participants, although we think it is the more likely and the more effective of the two. A step in this direction was taken at the August meeting, when the FOMC set mid-2013 as a likely minimum date through which overnight rates would be kept near zero. Most would agree this was a stop-gap measure: the economic literature suggests that a more optimal way of communicating future rate intentions when policy is stuck at the zero interest rate lower bound would be to condition that zero rate policy on economic conditions, rather than on the calendar.

Corporate bond balances hit a multi-year high toward the end of October.  The ongoing European debt crisis initially led to an increase in balances and activity.  The daily churn rate was high and borrowers actively borrowed securities, but trades did not stay open for long.  Starting in late October, running through the end of the year, balances fell as traders reduced their risk positions.  We continued to see high volumes, but returns outpaced new loans as market participants closed out both short and long positions.  High volumes of sales and recalls characterized the year-end, also leading to lower balances.  Borrowers focused on a limited number of specials where clients needed securities returned. These issues traded at steeper negative rebates as year-end approached. Other specials, without the pressure of being returned before year-end, actually loosened up and traded closer to a zero rebate.  Financials and sovereign credits remain in great demand, with examples including KfW Bankengruppe 2.625 percent notes maturing March 3, 2015 (cusip 500769DR2) and Credit Agricole SA perpetual bonds with a legal final maturity of October 13, 2049 (cusip 225313AB1).

International Fixed Income

Balances and volumes in the international fixed income -lending book increased again, following the strong growth we have seen throughout the last year. The same drivers remained - European sovereign specials, a spread between core and peripheral European sovereign issuers and significantly higher volume in the corporate bond book, especially financials. However, funding market strains have worsened in Europe and bank balance sheet impairment combined with uncoordinated regulatory pressure could cause severe deleveraging.

The importance of the private repo market is often underestimated - but a 6 monthly ICMA survey puts this market at €6.2 trillion (excluding repos transacted with central banks) - which dwarfs the repo operations transacted via the ECB. A tightening of collateral requirements can cause rapid contractions in volumes and pricing, which are a function of funding demand and the asset balance of counterparties. Scarce availability of high quality collateral has led to GC repo trading at very rich levels. Over year end Euro AAA GC repo traded at negative rebate rates. As the crisis grows, the risk is that counterparty credit risk and increased volatility of underlying bonds leads to a greater desire to hold high quality collateral, which increases repo-financing costs appreciably. As general liquidity dries up in the market, the amount of eligible collateral available also decreases as anyone holding the quality collateral is increasingly likely to hold onto it in the case of a further decline in conditions.