Update from the Fixed Income Desk - 2Q 2013
U.S. Fixed Income
During the second quarter, Treasury, Agency and mortgage-backed security (“MBS”) general collateral (“GC” ) rebate rates steadily declined, averaging 12.8 basis points for the period and trading in a range of .002%-0.25%. The combination of maturing cash management bills in mid-April and reductions in weekly bill issuance created downward pressure, with less Treasury supply in the market. In conjunction with low rebate rates, many of the current issues traded special. Notably, the current 10-year note (1.75% 5/23-CUSIP 912828VB3) traded at a deep negative rate before the June 17 reopening of $21 billion worth of the notes settling in the market. Agency collateral continued to trade in a narrow range of two to three basis points above Treasury GC while mortgage-backed collateral traded in a three to four basis points range. Balance sheet considerations remain a large concern for dealers, which continues to challenge utilization for these asset classes.
As we have seen in the past, the actions of the Federal Reserve tend to have a direct impact on lending programs. With lower rebate rates, we have been able to lend Treasury GC for accounts that have investment guidelines that are able to support these trades. We continue to see demand for non-cash trades and have expanded the eligible list of pledge collateral, including high rated Eurozone sovereign debt and Japanese Government Bonds (“JGBs”). Lenders who approve the expanded pledge collateral sets have the flexibility to participate in these trades when we have the opportunity to structure a trade.
Balances remained range bound through the second quarter. Borrowers continued to contribute to a very high churn rate as trades were put on and taken off rapidly. Borrowers focused on rerating their specials and were particularly quick to return securities that began to trade closer to general collateral levels.
Balances did dip briefly in late May when Fed funds started to consistently open below 10 basis points and GC began to trade consistently at a negative rebate. After the initial reaction of closing out trades and several trading sessions of reduced activity, balances returned to the general range where they have been for the past several quarters. Activity generally tails off through the first two months of the third quarter as market participants pare back risk prior to summer vacations. After Labor Day, activity generally increases, leading into the fourth quarter.
Balances in the international fixed income lending book increased strongly at the beginning of the second quarter but declined during June and ended up back where they had started – as improving market sentiment and the end of the European dividend season led to less demand for core euro sovereign GC. Core GC repo markets cheapened slightly, with the AAA/AA issuers pricing around 0.03% in short dates, as the unwind in dividend season demand, coupled with ongoing Long-Term Refinancing Operation (“LTRO”) repayments, started to have some effect on front-end rates. A high number of specials remained, especially the German 5-7-year maturities. Specific issues were volatile but remained special for the entire period. Balance in the corporate bond book increased over the quarter, and continues to be helped by the automation of shorts coverage through Bondlend. Liquidity generally remains good and we are still not seeing any significant numbers of long-term fails. Volumes remained very high as dealers continued to closely manage their balance sheet.
The European Central Bank, as expected, kept the main refinancing rate at 0.50% as improving confidence underscored President Mario Draghi’s timetable for an economic recovery later this year. Following the decision, Draghi noted that the ECB continued to expect economic activity to stabilize and moderately rebound during the second part of 2013. The Bank of England kept rates and quantitative easing unchanged, with Governor Mervin King losing his final monetary policy vote as the MPC voted 6-3 to keep the target of its bond purchase program at £375 billion.
In the U.S., we expect rates and spreads to remain in the range we have seen recently and repo markets to remain stable overall. With the Fed’s June announcement that it could start tapering its current Quantitative Easing (“QE3”) asset purchases “later this year” and complete the program by mid-2014, it may have little impact in the short run. Instead, with the Fed likely to keep the 0-0.25% funds target for quite some time thereafter, the focus remains on the effects of ongoing reductions in bill supply, the potential for coupon reductions later this year, money fund balances and the demand for high-quality collateral for margin purposes due to derivatives reform. In addition, the spread between collateral classes (U.S. Treasuries vs. MBS) remains stable in term markets at this time.
In Europe, demand will remain for high quality European sovereign GC, 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 is still 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, though close to GC levels. With Eonia and Sonia likely to remain low and stable for the immediate future, the bulk of our activity will remain on open, with little term lending opportunity.