Latest blog from Rob Verrillo, CEO @ ConneXXion Markets
What do central banks do next?
QE/QT and market dislocation.
What’s on the way for repo and financing markets?
Excess QE, post the need for it, was one of the primary causes of current inflation.
The initial round of QE was a legitimate policy response to calm financial markets as the pandemic took hold in 2019, credit spreads narrowed and liquidity increased dramatically following its implementation.
However, central banks kept printing long after it was required (and governments kept spending).
As a result, the unprecedented broad money supply increase, followed by a return of demand to pre-crisis levels as lockdowns lifted, saw a dramatic increase in nominal spending. This, exacerbated by supply-side price pressure (e.g., the war in Ukraine, Brexit for the UK), was the precursor to current high inflation levels.
The catalyst for current unruly Inflation was principally the result of excessive monetary expansion in 2020 and 2021, and countries where monetary growth has been pursued aggressively as a COVID policy response have seen some of the most dramatic and pronounced acceleration in inflation.
“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output......the important next step is to recognise that today the governments control the quantity of money ...”
Milton Freidman.
Central bank response to the looming inflation problem was slow
Monetary policy response has always seemed to be lagging and backwards-looking, leaving central banks playing catch up...
Central banks have raised rates hard and fast, and have embarked on liquidity withdrawal via QT.
Since March 2022 the Federal Reserve has embarked on its most aggressive series of hikes in four decades and is shrinking its balance sheet by almost $60bn a month.
Have they gone too fast/ far/ or underestimated the effects of rapid liquidity withdrawal?
The more dependent markets become on central bank stimulus to justify credit spreads and valuations, the more susceptible they are to the eventual withdrawal from these policies by the central banks.
Charlie Bean's analogy was spot on; you can pull on the elastic band around a brick for a while without any movement, then suddenly that brick comes at you fast...
M2 has contracted at the fastest pace since the great depression....
Extreme excess liquidity helped push valuations up strongly during the pandemic recovery. The flip side of this is that its withdrawal may well punish the markets. The risk of disorderly falls in asset markets remains high, credit and risk appetite are showing signs of diminishing and a rapid change in valuations could still trigger potentially severe market dislocation.
The scale and pace of monetary contraction has taken many by surprise (e.g., LDI market in September 22 and US regional banks in March 23), not least because central banks perhaps should have acted way sooner to end QE and begin rate “normalisation”. This contraction has served to expose operational and risk management weaknesses in both of those markets, which is perhaps unsurprising given 10 years of very low rates and limited volatility, complacency in VAR models manifest.
The effects of this global shift and tightening of credit and money may not be fully appreciated or priced in and I suspect that it can still lead to large asset price re-pricing and significant volatility. “Carry trades” may well get carried out...and investors would do well to at the very least ensure they are “nimble” for the next 12/18 months.
Investors always fear “missing the boat”, whilst I believe that they should be more inclined to try and “dodge the bullet...”
Where are markets showing signs of strain?
Central bank intervention in disorderly markets has and will become more commonplace. Regional banks remain under pressure, despite Fed intervention valuing many of their assets at par rather than their true MtM value. *
A clear area of concern is the commercial real estate (CRE) market and loans secured against it.
The estimated. $21Tn US CRE market has lots of refinancing to do ($162bn maturing loans in 2023), at much higher rates than a year ago, while CRE values are being marked down by 20-30% in some cases.
Meanwhile, office-based real estate investment trusts (REITs) measured by the FTSE Nariet Equity REIT Index dropped 37.6% in 2022 and another 18.1% in the first four months of this year.
A recent report in the FT, that HSBC (and others) are actively reducing their CRE loan exposures by selling “performing” loans at a discount is an additional concern. Selling fixed rate loans at a loss because interest rates have risen incurs losses, which can impact bank capital and share price and impact investor confidence, they do not risk this lightly, so banks off-loading CRE loans is a sign of real precaution and concern. There are many corporations (and individuals) sitting on very low cost of funding, when they go to refinance, the cost could double/triple – assuming they can refinance that is. Datasets are increasingly evidencing the stagnation of loans & leases.
Banks are tightening credit and are being conservative and far more stringent in their loan assessment.
U.S. national debt is up $572bn since the (perhaps ironically named) “Fiscal Responsibility Act 2023” was passed 2 weeks ago to $32 trillion ...taking national debt in the U.S. to 50%
higher now than it was 5 years ago. Politicians must wake up and realise that money isn’t free and that the era of QE and near zero rates is now over.
U.S. debt ceiling suspension until 2025 has allowed the printing press to fire up once again and the U.S Treasury is now set to issue a net $1 trillion of bills into the most systemically important market over the next year.
If the short end is impaired, everything else is affected.
Risk absorption and intermediation
Aggressive QT and issuance will reduce the cash balances of banks. The combination of a positive supply shock and negative demand shock can lead to violent dislocations – who is going to take up the slack?
After the GFC, regulations forced banks to hold more qualifying assets, as part of the Supplementary Leverage Ratio (SLR) covering various on and off-balance sheet assets and exposures. This effectively limited the ability of primary dealers to intervene or provide intermediation in times of market stress. Hedge-funds, high frequency traders, and other institutional investors (non-bank financials or NDF’s) are not suitable to fulfil that role. Indeed, it is large leveraged bets from some of these market participants which can exacerbate these very same liquidity events.
Government deficits have grown, and have continued to outpace the already constrained primary dealers’ ability to absorb extra issuance. The withdrawal of QE in late 2022 has exacerbated this issue, as the largest purchaser of government paper has withdrawn from the market. Together, greater supply and a more limited ability to meet it has led to a systematically more fragmented and fragile market.
Whilst regulation post GFC has made Banks inherently safer, they have made markets inherently less liquid. As risk has shifted to non-bank financials and CCP’s, intermediation capacity has fallen, meaning that the “depth” of markets, and the capacity to absorb shocks, has decreased.
CCP usage has served to concentrate risk from one area of “too big to fail” (the banks) to another, (CCP’s).
Mutualisation of risk via a CCP makes members vulnerable to others members’ default risk.
Regulators, in trying to “fix” where market risk sits, have only served to shift it away from a series of mini shock absorbers (the banks) to huge systemically important risk warehouses (CCP’s) where all members are at risk of incurring losses should one of them fail.
Should there be discomfort for example, about the financial state of a certain CCP member, it is very likely that credit risk officers will instruct banks to reduce their exposure to the CCP, which could have the knock-on effect of reducing liquidity for the entire market rather than isolating just the institution in question.
I remain to be convinced that the drive toward direct or indirect CCP membership is mutually compatible with mitigating financial stability concerns.
It seems reasonable to expect increasing regulation and oversight of CCP’s and subsequently the cost of their use to increase, which may very well render sponsored membership for many buy-side firms to be too costly, cumbersome to implement whilst giving them only limited liquidity benefits in times of stress.
The U.S. repo market
Money Market (MMF) excess cash balances currently sitting in the Fed and their short-term investments in bank issued CD’s/CP may diminish as the Fed embarks on its T-Bill issuance extravaganza. The yield of these bills must outperform not only the RRP rate but also SOFR (the Secured Overnight Financing Rate), in order for MMF’s to step in and be tempted by this supply. Currently U.S. MMF's are 85% Government & Treasury funds (~$4.4Trn.) with roughly half their overall liquidity in Fed RRP. By regulation these funds need to maintain 10% in overnight and 30% in weekly liquidity, meaning they are heavily dependent on a facility that is likely to diminish in short order. While MMF levels are close to record highs, this is unlikely to fall at the same pace as M2 given heightened concern from institutional investors on uninsured deposits and pressure on banks to limit rate paid on wholesale deposits.
As the Fed embarks on mammoth T-Bill issuance, it is unlikely that MMF's will be able to pivot and buy into this new supply.
Should MMF’s NOT step in to buy this additional T-Bill issuance, corporate treasurers, sovereign wealth funds and other natural holders of short-term cash will. This has a knock-on effect of squeezing cash deposits and reserves at Banks.
The spreads demanded for reverse repo will increase, because demand is increasing whilst QT and issuance is shrinking the supply of cash to the market.
In addition, new Basel 4 hits this year and reports in the U.S. for example are speculating on a 20% additional capital requirement for US banks.
https://www.reuters.com/business/finance/us-banks-could-face-20-boost-capital-requireme nts-wsj-2023-06-05/
Finally, what does this mean for global repo markets?
The era of cheap and plentiful balance sheet is rapidly coming to an end. Currently, many banks allocate a 20% risk weight to 000’s of unrated, but high-quality counterparties like pension and mutual funds. The standardised rules of Basel 4 state that unrated obligors will attract a phased-in 100% risk weight allocation going forward. Buy side market participants would do well to examine alternative and additional liquidity provision.
As central banks globally scale back QE via QT, and issuance of national debt continues at a pace, banks will be expected (and I suspect get paid for via yields) to take up the slack.
The lesson of the prior QT was that reducing the cash balances of banks directly impacts markets that were recipients of that cash.
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* The U.S. banking system’s market value of assets is $2.2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. Most of these asset declines were not hedged by banks with use of interest rate derivatives.
The views and opinions expressed herein are those of the author and do not necessarily reflect the official position of ConneXXion Markets. They are based upon information the author considers reliable, but should not be taken as investment advice and ConneXXion markets does not warrant the completeness or accuracy of any statements made herein.
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