Update from the Fixed Income Desk - 1Q 2013
U.S. Fixed Income
Since the beginning of the 2013, Treasury general collateral (GC) rates have declined sharply from the elevated levels traded in the last quarter of 2012. There are multiple factors contributing to the decline in rates. First, Operation Twist was completed at the end of last year, removing a significant supply of Treasuries from dealer balance sheets. Second, the expiration of the Transaction Account Guarantee (TAG) program has led some investors to move deposits into the repo market. Lastly, and maybe most importantly, the ongoing impact of the Fed's open-ended monthly purchases of $85 billion of Treasuries and Agency MBS (QE3/4) has caused rates to decline abruptly as excess reserves increase.
Historically, the monetary policy actions of the Federal Reserve have had a direct impact on the lending program. With increased demand for Treasuries and decreased supply, we expect rates to continue to decline. Lower rebate rates allow us to lend Treasury GC for accounts that have investment guidelines able to support these trades.
Agency collateral has continued to trade in a narrow range of two to three basis points above Treasury GC while Mortgage-Backed GC has traded in a range of three to four basis points above Treasuries. Balance sheet considerations, highlighted on month-end and quarter-end, remain a large concern for dealers which, continue to challenge utilization for these assets classes.
We continue to see demand for non-cash trades and have expanded the eligible list of pledge collateral to include high rated Euro-zone Sovereign debt and Japanese Government Bonds (JGB). Lenders who approve the expanded pledge collateral sets have the flexibility to participate in these trades as borrower demand increases.
- With the Fed's $85 billion in monthly asset purchases, Treasury GC rates may trade low in the single digits to low-teens in the second quarter.
- The market will continue to be focused on both economic growth and job growth in the U.S.. If the economy continues to add jobs at a quick pace, we would expect the Fed to scale back their monthly purchases by late 2013.
- Funding needs from the RIETS will keep the pressure on MBS term rates.
- The Treasury Department left coupon auction sizes unchanged through at least early May, as expected. According to projections, current nominal coupon sizes and projected increases in TIPS issuance will be more than sufficient to cover the Treasury's financing requirements through 2015
- In mid April, we saw a reduction in Treasury bill issuance which should continue into May. The reduction in supply should help to push rebate rates lower.
- The Federal Reserve Bank of New York is launching a pilot program with small broker-dealers in an effort to examine options for further broadening access to monetary policy operations. The limited, one-year pilot program will allow no more than five small firms to participate solely as counterparties in outright purchases and sales of U.S. Treasury securities for the System Open Market Account (SOMA) portfolio. The Treasury Operations Counterparty Pilot Program is being launched as a way for the New York Fed to continue to explore the effectiveness and feasibility of expanding operations to a broader range of counterparties.
Trends that asserted themselves in the fourth quarter of 2012 continued to hold in the first quarter of 2013. Borrowers were reluctant to increase balances and acted quickly to cover trades, leading to a very high churn rate on loans. Traders were focused on headlines, with issuers like Dell Inc., H.J. Heinz Co., and Hewlett-Packard Co. trading special during the quarter.
Several headwinds have coalesced to mute demand to borrow corporate bonds. Global economic concerns, regulatory uncertainties, investor cash continuing to enter corporate bond funds, and spreads holding near all-time highs continue to make market participants hesitant to set new short positions. We anticipate brokers, with lighter borrowing needs, to focus on upgrading their books. This could lead to specials trading closer to general collateral levels or being returned.
Balances in international fixed income lending increased strongly throughout the first quarter of 2013, but were still off the highs seen at the beginning of 2012 – mainly as a result of improving market sentiment in the Eurozone leading to less demand for core euro sovereign general collateral. Volumes remained high, especially in the corporate bond markets, as dealers continued to micro-manage their balance sheet.
However, investor sentiment in the Eurozone remained strong – which meant that spreads between European sovereigns in the repo market were very tight – Italy and Spain continue to trade in the overnight market only a few basis points away from the AAA core countries. However, balances increased as a result of a higher number of specials, especially in the German four- to seven-year maturities. Specific issues were volatile but remained special for the entire period.
Corporate bond balances increased over the quarter, and continue to be helped by the automation of shorts coverage through Bondlend. European financials continue to be in high demand in the repo markets, which remain highly liquid. Corporate bond fails are minimal and short lived.
We expect demand to remain for high quality European sovereign general collateral, but, with spreads so tight in cross-currency trades, this opportunity will only be there for those lenders with three-month cash reinvestment guidelines, or those willing to participate in an upgrade trade. Outside of Europe, demand remains strong for Australian sovereigns, but spreads will remain under pressure as there are so few issues trading with any intrinsic value.
Specials will likely remain concentrated in shorter maturity German sovereigns and we will continue to see demand for under 10-year gilts, albeit at general collateral levels. With Eonia and Sonia likely to remain low and stable for the foreseeable future, the bulk of our activity will remain on open, with little term lending opportunity.