Insights from Our Fixed Income Desk - 3Q 2013
U.S. Fixed Income
The trend of low rates, which started at the beginning of the year, continued in the third quarter. The end of Operation Twist in 2012, a sharp reduction in Treasury bill issuance and the Federal Reserve's continuing asset purchase program ("QE3") of $85 billion in Treasuries and Mortgage Backed Securities ("MBS"), have created persistent downward pressure on repo rates. We expect this trend to continue for the remainder of 2013.
Recently, the Treasury began reducing the auction size of its two- and three-year benchmark Treasury coupon issues due to an improving fiscal outlook as a result of higher tax receipts. The two-year note has been reduced by $1 billion both in August and September and had previously been a $35 billion monthly issue since the third quarter of 2010. The three-year note was reduced by $1 billion in September from its $32 billion monthly auction size. Moreover, Treasury bill issuance is forecasted to decrease on a weekly basis into the fourth quarter, with the total reduction in supply leaving the market exceeding $100 billion. This reduction in supply supports our forecast of low repo rates continuing for the remainder of the year.
As we have seen in the past, the actions of the Federal Reserve have a direct impact on lending programs, with near-zero rates and continued large scale asset purchases removing supply from the market. With lower rebate rates we have been able to lend Treasury General Collateral ("GC") for accounts that have investment guidelines able to support these trades. Additionally, we continue to see demand for non-cash trades and have expanded the eligible list of pledge collateral to include high-rated Eurozone sovereign debt as well as Japanese Government Bonds. Lenders who approve expanded pledge collateral schedules have the flexibility to participate in these trades when we have the opportunity to structure a trade. Agency collateral continued to trade in a narrow range of two to three basis points above Treasury GC while mortgagebacked 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 during the third quarter, as markets were very quiet through the summer. Trades covered positions and borrowing activity fell off through the middle of August. As Labor Day approached, borrowers became very active with locate lists. However, very few trades were executed off those lists.
Balances in September did recover, with very high daily volumes, but the turnover rate also remained high. On September 18, Verizon settled the largest corporate bond deal in history. Across multiple tranches, Verizon issued $49 billion of new debt, more than double Apple Inc.'s issuance in April. We did see increased activity in telecommunications bonds issued by companies such as AT&T Inc. leading up to the deal. However, any uptick in borrowing was short lived. Borrowers were able to settle the new issue very quickly, and with the bonds rallying in the cash markets, traders were very quick to cover their shorts. With a normal increase of activity ahead of quarter end, we anticipate demand for corporate bonds to remain robust through early November. As the holidays approach, most market participants will be focused on closing out trades and cleaning up fails prior to year-end.
U.S. – Looking Forward
- We believe that lending rates will continue to trade with a downward bias, likely averaging in the high single digits through year-end
- The Federal Reserve has maintained a decidedly dovish stance and has maintained its monthly asset purchases of $85 billion Treasuries and MBS. The Federal Open Market Committee has stated that these "asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment"
- As J.P. Morgan expected, the government shutdown and debate over the U.S. debt limit affected markets globally. On October 16, the debt limit was temporarily increased through February 7, and the U.S. government reopened through January 15, pending further resolution
- We anticipate further impacts to the repo market with regulations from the Volcker Rule ban on proprietary trading as part of the Dodd-Frank Act, to risk-weighted asset requirements and new supplementary leverage ratios under Basel III rules
Balances in the international fixed income lending book remained within a fairly narrow range during the third quarter, ending September flat to where we started in July. Core European GC repo markets were also very stable, trading at just above zero for the entire quarter. We saw a gradual tightening of core to peripheral repo spreads, with Spain and Italy trading just three basis points and five basis points respectively, to AAA issuers in short dates towards the end of the period. A high number of specials remained, especially in the German four- to seven- year maturities. Specific issues were volatile day-to-day but remained special for the entire quarter.
Balance in the corporate bond book increased strongly in the first part of the quarter, reaching an all time high towards the end of August, before dropping off towards quarter end as borrowers managed balance sheets. Activity levels continue to be helped by further automation of shorts coverage through BondLend, though the turnover rate is high, meaning that the average tenor of loans is shorter than in previous periods. Liquidity generally remains good and we are still seeing very few longterm fails. Specials remain concentrated on the less liquid, higher yield issues.
The European Central Bank, as expected, kept its benchmark interest rate unchanged at a record low after economic data signaled that the Euro-area may be recovering from its longest-ever recession. The Bank of England ("BOE") left its benchmark rate and Quantitative Easing target unchanged (0.5% and £375 billion, respectively), while Governor Carney's first policy decision on July 4 marked the central bank's first steps into forward guidance, with the Monetary Policy Committee issuing a statement indicating that investors' expectations of when the BOE would begin rate increases were premature.
International – Looking Forward
Demand remains for high quality European sovereign GC, but with spreads so tight in cross currency trades, only those lenders with three-month euro cash reinvestment guidelines will be able to take advantage of this opportunity. Term levels indicate that specials will remain concentrated in shorter maturity German sovereigns. There is increasing demand for local currency Eastern European bonds, such as Poland, Hungary and Romania. Outside of Europe, demand will remain strong for Australian sovereigns, but spreads remain under pressure, as there are so few issues trading with any intrinsic value. Euro OverNight Index Average ("Eonia") and Sterling OverNight Index Average ("Sonia") remain low and stable so the bulk of our activity will remain on open, with very little term lending opportunity.