Insights from Our Fixed Income Desk - Issue 1, 2014
U.S. Fixed Income
The trend of low rates which started at the beginning of the year continued in the fourth quarter. The end of Operation Twist in 2012, a sharp reduction in Treasury bill issuance and the Federal Reserve Bank’s (FRB) monthly asset purchase program (QE3) of $85 billion Treasuries and MBS, created persistent downward pressure on repo rates for much of the year.
The trend of low rates which started at the beginning of the year continued in the fourth quarter. The end of Operation Twist in 2012, a sharp reduction in Treasury bill issuance and the Federal Reserve Bank’s (FRB) monthly asset purchase program (QE3) of $85 billion Treasuries and MBS, created persistent downward pressure on repo rates for much of the year. The potential for tapering has existed since QE began as QE was never intended to last forever. In past communications Bernanke had made it clear that the continuation of the program was dependant on incoming economic data. After much anticipation, the Federal Reserve announced it will taper its purchases by $10 billion per month as of January. This will include $35 billion of MBS and $40 billion of Treasuries, $5 billion less of each. Assuming the economy remains healthy, it will look to cut the monthly amount of its purchases in $10 billion increments at subsequent meetings. If the FRB proceeds at the pace it set out, it will complete the bond buying program the end of 2014 with asset holdings of nearly $4.5 trillion.1 This is almost six times as large as The Federal Reserve Bank’s total holdings when the financial crisis started in 2008.
As we have seen in the past, the actions of the Federal Reserve Bank have a direct impact on the lending program. The FRB actions have led to lower rebates. With lower rebate rates we have been able to lend Treasury general collateral for lenders that have cash collateral guideline able to support these trades. Additionally, we continue to see demand for non-cash collateral trades and have expanded the eligible list of pledge collateral to include high rated Eurozone sovereign debt as well as Japanese Government Bonds (JGBs). Lenders who approve the expanded collateral schedules have the opportunity to participate in these trades when the opportunity is presented. Agency collateral continued to trade in a narrow range of two to three basis points above treasury general collateral while mortgage backed collateral traded in a three to four basis points range. The spread between one and three month term tenors remained narrow for the reporting period. Balance sheet considerations remain a large concern for dealers, which continues to challenge utilization for these assets classes.
Corporate bond balances fell each month in the fourth quarter of 2013, as market participants were reluctant to put risk back on their books after summer vacations. Daily volumes remained very high throughout the quarter, but the turnover rate was even higher. Loans did not remain open for long periods, and borrowers were consistently focused on upgrading the rates on their borrows.
With borrowers constantly moving their borrows from one lender to another, keeping specials on loan became very difficult. Whenever a cusip began to trade special and at a deep negative rebate, borrowers seemed to consistently be able to find a more favorable rate. This led to frequent re-rate requests and to loans being closed out. As activity tapered off in December, this trend became even more pronounced, and keeping specials out at aggressive levels was extremely difficult.
J.P. Morgan anticipates an increase in activity in the first quarter of 2014. The new issue calendar is traditionally very active early in the year. Corporate bond spreads rallied strongly the last six weeks of 2013. With an improving economy, and spreads set to potentially widen for the first time since the financial crisis, we could see increased demand to short corporate bonds.
Ongoing fiscal, monetary and regulatory policy changes will continue to shape the lending/repo markets in 2014;
- The Federal Reverse Repo facility - although in a test phase, speculation is this will likely be used as a monetary tool (The reverse repo facility allows money-market funds and some government-sponsored enterprises, in addition to banks and broker-dealers, to lend the FRB cash overnight at a fixed rate with Treasuries as collateral for the loans).
- Borrowers decreasing allocation and more expensive balance sheet costs. Low margin, capital intensive trades will become harder to justify, or will need to be more prudently priced which may make repo more expensive (higher lending rates).
- The FRB tapering of monthly purchases will add more supply to the market pushing rates higher.
- Debt ceiling concerns have in the past pushed short rates higher in the both the repo and outright market.
International Fixed Income
Balances in the international fixed income lending book were steady in October 2013 but then declined during the final two months of the year, as borrowers focused on year end balance sheet management. It looks like demand will pick up strongly in the New Year and we should soon see balances return to pre year end levels. Core EUR general collateral (GC) repo markets were stable in October and November, trading at just above zero, before rebates increased during December, spiking significantly only for one day over the turn of the year. Due to weak growth outlook, S&P downgraded the Netherlands sovereign credit rating to AA+, leaving just Germany, Finland and Luxembourg with AAA status. A reasonable number of sovereign specials remained, especially in the German 4-7 year maturities - specific issues were volatile day to day but remained special for the entire quarter.
Spain and Italy traded very close to AAA issuers in short dated repo with yields in these bonds reflecting increased investor confidence in peripheral sovereigns – indeed, the yield on the Spanish 2 year fell to 1.06% in the first few days of 2014, the lowest since Bloomberg began compiling data in 1993. Moody’s improved the rating of the Spanish sovereign from negative to stable outlook (rating remains at Baa3) but the change to stable is material as Moody’s was the main threat to Spain losing its investment grade from all the major rating agencies. Peripheral GC now trades in good size in term in the repo market.
The corporate bond balance also declined during the quarter, after having reached an all time high towards the end of August 2013. Activity levels continue to be helped by further automation of shorts covered through Bondlend, though the turnover rate by borrowers remains very high. Despite the dealers holding fewer inventories, liquidity generally remains good and we are still seeing very few long-term fails. Specials do remain concentrated in the least liquid high yield issues.
Since the cut to the benchmark ECB rate in November, data has shown that the euro area’s economic rebound has come to an almost halt with growth of just 0.1% for the third quarter.2 Policy makers were keen to state that they had not exhausted their room to cut interest rates and have a variety of measures at their disposal. One unprecedented option that officials have discussed is charging banks for the excess liquidity they place at the ECB, making it the first major central bank to venture into negative deposit rates. Whilst technically ready, the consequences are not clear – if banks are not able to pass on the costs to the depositors thereby squeezing their profit margins, it could deter them from lending to companies, households or each other.
Demand remains, for high quality European sovereign bonds, general collateral. With spreads so tight in cross currency trades, this opportunity is viable for those lenders with 3 month EUR cash reinvestment guidelines. Despite much industry talk of a collateral squeeze, it is yet to materialise and there is little indication at this point that demand for high quality liquid assets (HQLA) will outstrip supply and start to drive fees higher.
Demand for sub 10 year gilts will continue, albeit at GC fees, due to the punitive haircuts charged by LCH to the dealers for settling trades in longer dated paper.
On the specials side, the 3-7yr part of the German curve will remain volatile and expensive. Upcoming taps will also drive fees higher for those issues until the new supply settles. There is continued demand for local currency eastern European bonds, such as Poland, Hungary and Romania.
2. The Gross Domestic Product (GDP) In the Euro Area expanded 0.10 percent in the third quarter of 2013 over the previous quarter. GDP Growth Rate In the Euro Area is reported by the Eurostat. Eurostat is a Directorate-General of the European Commission located in Luxembourg. Its main responsibilities are to provide statistical information to the institutions of the European Union (EU) and to promote the harmonisation of statistical methods across its member states and candidates for accession as well as EFTA countries.