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Something strange is happening in the financial plumbing that makes Wall Street — and by extension, the global economy — function.
Overnight lending rates in an esoteric financing market frequently tapped by banks, hedge funds and other borrowers spiked last Friday, prompting comparisons to a surge in short-term lending rates in September 2019 that forced the Federal Reserve to step in to ensure that credit would keep flowing smoothly through the U.S. financial system.
See: Here are five things to know about the recent repo market operations
Spike rattles Wall Street
Six basis points might not seem like much. It is equivalent to just 0.06 of a percentage point. Such a swing would barely register in the U.S. equity market.
But when a financing rate that undergirds trillions of dollars worth of financial products and short-term loans suddenly sees a move of this magnitude, Wall Street can’t help but take notice.
That is exactly what happened on Dec. 1, when the secured overnight financing rate — a broad measure of the cost for institutions, often banks but also money-market funds and hedge funds, to borrow money overnight using Treasurys as collateral — suddenly spiked from 5.33% to 5.39%, according to data collected by the Federal Reserve.
Although the spike quickly faded, some analysts expressed concerns that it could happen again as the Fed’s quantitative tightening campaign heaps more stress on the nearly $26 trillion market for U.S. government debt — and by extension, the lending markets where these bonds are used as collateral.
Why is this happening?
The type of “sponsored” repo financing that uses SOFR has seen its popularity grow rapidly this year, causing volumes to soar.
In a matched-book repo trade, a dealer would borrow from a cash-rich lender, such as a money-market fund, and then lend those proceeds on to a cash-rich borrower, such as a hedge fund, in exchange for collateral, with the dealer putting up its own capital against the repo exposure. As explained in this primer from JPMorgan, a sponsored-repo transaction sees the Fixed Income Clearing Corp., a clearinghouse, intermediate both sides of the trade, which allows dealers to net the transactions off against each other.
That significantly reduces the amount of capital banks have to hold, allowing dealers to offer more of their balance sheet to clients or deploy capital toward other uses, JPMorgan explained.
But the rise in demand means their capacity to absorb new collateral has shrunk, increasing the costs for furnishing this type of financing and forcing them to raise prices for borrowers, according to Nomura’s Ryan Plantz.
“The Treasury rally has boosted the demand for secured funding faster than dealer balance sheets’ capacity to supply it,” said Barclays’ Joseph Abate, who discussed the spike in a note to clients shared with MarketWatch earlier this week.
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In his report, Abate attributed the sudden increase to “several market factors and a little bit of unfortunate timing.”
“First, the sharp Treasury market rally since October has pushed up financing demand for long positions. It is unclear whether this demand is coming entirely from leveraged cash futures basis trades, or simply cash positions. That said, the speed of the rally appears to have overwhelmed the capacity of dealers’ balance sheets to expand quickly enough to accommodate the increase,” he said.
“As dealers struggled to make room on their balance sheets, they have pushed more activity into the sponsored repo market. Volumes jumped to a record $943bn, and since late October, the repo funding leg has grown by $100 billion,” Abate added.
Treasurys have rallied hard over the past six weeks. Since it briefly touched 5.02% on Oct. 23, the yield on the 10-year note
BX:TMUBMUSD10Y
has fallen to 4.10% as of late Wednesday, according to FactSet. November saw the largest one-month yield decline for the 10-year since August 2019, per Dow Jones Market Data.
What’s next?
While Friday’s spike has already faded, Nomura’s Plantz says he expects this won’t be the last time it happens. He expects to see more volatility in financing markets as the Fed’s shrinking of its balance sheet leaves Treasury dealers stuffed with collateral.
“Simply put, you are starting to see some of the implications of QT as well as sponsored repo coming home to roost,” he said.
The timing of the move is also notable, occurring as the basis trade, a popular trading strategy that relies on cheap leverage, draws scrutiny from regulators and others on Wall Street.
For those who are unfamiliar with the basis trade, it is a strategy typically employed by hedge funds that is designed to profit off the spread between Treasury bonds and Treasury bond futures contracts.
See: Hedge funds’ use of leveraged Treasury trades needs ‘diligent monitoring,’ Fed paper says
Does this spike mean U.S. lending markets are destined to see a repeat of 2019, potentially forcing the Fed to reconsider continuing with its quantitative tightening? That is unlikely, according to Plantz and Abate.
However, the notion that this surge could repeat itself despite all the mechanisms the Fed has put in place, including its standing repo facility, to try to keep these markets running smoothly is reason enough for investors to keep a close eye on things.
And even if the spike in financing costs remains contained, it could have knock-on effects in capital markets, according to Plantz’s colleague, Charlie McElligott, a derivatives-market guru at Nomura.
As the availability of this type of financing declines, sophisticated traders that rely on leverage might opt to take their chips off the table, instead of letting their winning trades run into the end of the year.
Read: How a shrinking cash pile at the Fed can aid liquidity in the $26 trillion Treasury market
That could already be impacting markets this week, as a rally in U.S. stocks has stalled, even as Treasury yields, which move inversely to bond prices, have continued to slide.
