Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Investors took heed in September when overnight rates soared from ~2% to over 10% as demand for overnight funding outpaced supply. The contagion spread to elevate Fed Funds above the Interest Rate on Excess Reserves (IOER) toward the uppermost part of the Fed Funds range. The last time short term rates created such a commotion was during the financial crisis of 2008. The common question raised is whether this apparent sudden lack of short term liquidity is a warning or precursor to a much larger problem and how will it affect the average investor?
The repo market allows companies that need cash and own high-quality securities to inexpensively borrow cash by using those securities as collateral. In exchange, companies with a lot of cash earn small returns with little risk by lending money. The exchange works because the companies that borrow the cash agree to repurchase their securities typically in a very short period of time, such as overnight. What happened in September is that cash suppliers were fewer than borrowers so the demand for cash pushed the rate higher.
At the time, some blame was ascribed to a convergence of specific demands which included: corporate quarterly tax payments and people wanting to borrow cash to finance a Treasury auction settlement. In addition, the government’s growing budget tests the market’s ability to absorb the requisite Treasuries funding it. The reality, however, may be more structural citing the Fed’s balance sheet reduction. The Fed started to reduce its balance sheet in the 4th quarter, 2017 and discontinued that reduction in August of 2019. Excess reserves held at the Fed peaked at $2.7 trillion in September 2014 and have since fallen to $1.36 trillion. Banks that typically supply money in the repo market have less cash available to do so as their excess reserves decline.
The Federal Reserve pays interest (IOER) on excess reserve balances that depository institutions have at Reserve Banks. The IOER gives the Fed a tool to conduct monetary policy. When the Financial crisis of 2008 hit, the Fed instituted Quantitative Easing (QE) to ensure sufficient liquidity during the crisis. As they purchased Treasuries and Mortgaged-Back bonds from banks, they in essence injected the banks with large amounts of cash. By increasing the IOER, which is typically a higher rate versus Fed Funds or other money market rates, the Fed incentivized the banks to hold the cash as Excess Reserves thereby locking in low risk profits and preventing these funds from increasing the money supply if the banks created loans or bought financial assets. The Fed’s incentive was to control the potential inflationary consequences if the excess money turned into bank loans and eventually flowed into goods and services.
In actuality, banks leveraged some of these reserves through the financial markets contributing to higher stock/bond prices and tightening of credit spreads.
In September, demand for cash became higher than the supply. The Fed began overnight repo operations injecting $50-$75 billion into the repo market. This temporary liquidity injection worked and brought the repo rates back to normal. In October, the Fed started buying $60 billion/month in T-Bills as a longer-term solution to the liquidity needs. Fed Chair Powell has couched the move as a “technical” adjustment to the open market operation. Some financial pundits dismiss this as just semantics. If the Fed’s balance sheet is growing, it is another form of quantitative easing. At the end of August, the Fed’s balance sheet was down to $3.76 trillion. As of November 13, it is back up to $4.05 trillion. Over the same time frame, the S&P has jumped ~7%.
What does this all mean? Excess reserves which were created over the last decade as a result of the 2008 Financial Crisis may not be as ample or play as significant a role in funding the overnight money markets going forward. Monetary policies have driven financial market consequences and will likely continue to reshape market functionality such as overnight funding. The evolution taking place has driven extraordinary Fed action and the consequences of monetary policy have become far reaching. Prolonged global interest rate disparity has driven demand into the U.S. and been a contributing factor to preventing higher rates. This, in turn, has forced some investors into riskier and/or more illiquid alternatives. The bigger evolving question seems to be, “How will all of this unwind in time”?
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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