One of our regular themes over the past two years has been the shortage of collateral to facilitate the very short-term lending done through repos. As our friends at CrossBorder Capital often say, we now live in a world where refinancing is much more important than financing, and the repo market is a critical element. The biggest financial event in 2021 has been the explosion in repo volumes initiated by the Federal Reserve. In this article we go down in the weeds and try and unpick what is happening here.
Two and a half years ago we thought the Federal Reserve’s volte face on interest rates was driven principally by fears that the repo market would dry up through lack of safe collateral (originally T-bonds but since extended to other high-quality assets). Their fear was this could cause a systemic collapse in corporate debt markets because so many companies rely on repos to refinance their debt.
When COVID broke in March 2020 and central banks flooded the market with liquidity, this worry temporarily went away. It explains why corporate bond yields compressed right across the risk spectrum. But about six months ago, the Fed. upped the pace of repos, using a large part of the bonds they have issued as collateral. The level has almost doubled from an annualised rate of about $2.7 trillion to about $6 trillion.
One explanation of this is ‘stealth tightening’ – i.e. the Fed. wants to mitigate the inflationary impulse given by QE4. A more benign one is that this is tactical - a way of keeping money market rates aligned with the Fed.’s target. The outcome is clear: while the huge level of bond issuance increases the supply of safe assets to use as collateral, this activity seems to be soaking up a lot of the headline monetary easing. So why is the Fed. doing it?
The obvious explanation is inflation. Raising rates is looking less and less likely with COVID on the rise and parts of the economy still struggling. But the Fed. cannot ignore the possibility that the sharp rise in high street inflation may turn into something more sustained. It also has to be careful how it tapers off QE to avoid another bond market tantrum as happened in 2013. Soaking up some of it via the repo markets is its solution.
CrossBorder give a good table of the various Fed. QE impulses, in the link here.
Their take on the future is that the Fed’s giving with one hand (bond issuance) and taking with the other (reverse repo activity) is likely to increase investor demand for safe assets. If the intention is to tighten without making it too obvious, we can expect it to have a negative effect on the economy. For investors, it is a clear pointer that we are moving to ‘risk off’.
We are clearly past the peak of liquidity, whatever the reason for the Fed.’s repo activities. The evidence is building that we are at or even past the peak in equities. The big question is now whether we are already past the peak in economic growth.
Here we will turn the spotlight onto China. The economy is larger than the U.S. in PPP terms and has a higher global multiplier because it is more actively trading and investing in the world. Recent data from China is showing a sharp tightening in liquidity. No great surprises that short term bond yields are down from 3% to just above 2% in 2021. The PBOC has eased in recent days, but it points to a significant slowdown in Chinese activity, and that in turn will impact the world.
A month ago we ‘called’ the turn in equity markets. In our view, while we are not expecting a dramatic sell-off, the risks continue gradually to rise for equities. We do not believe western central banks can afford to tighten much because of the need to refinance the debt burden. The key question will be whether the PBOC decides to ease further.
Meanwhile, we are not surprised that western bond yields have continued to fall, and we think that will carry on. It may sound perverse to suggest we are heading for Japanese-style deflation when the headline inflation numbers are so high, but we are always more comfortable when our position is away from the consensus and in our view the risk of that scenario is rising.