The short-term fixed income markets can be a source of great mystery for investors. For example, see if you can answer these questions:
- What is the most actively traded financial instrument in the world by volume?
- Who owns more T-bills: government money market funds or the U.S. Federal Reserve?
- What is IOER? (hint: it has nothing to do the refrain from “Old MacDonald had a Farm”)
The money markets are important for all investors because they are one of the early warning signs of credit risk and supply/demand imbalances. Short term debt instruments are constantly repricing, forcing investors to make relative value decisions on a constant basis. As much as some other commonly monitored “Canaries in the Coal Mine” indicators like implied volatility and the shape of the yield curve, the money markets may hold valuable information regarding future economic conditions.
So, what is happening in these markets today? A lot….
- First, the money markets are clearly saying “No Fed Activity” for the foreseeable future. On Display 1, the thick blue line represents the yield on U.S. Treasury Bills from 1 day to 12 weeks. With all maturities yielding 2.40% – 2.41%, the T-bill market implies no change to Fed policy through July; in fact, even one-year T-bills yield 2.40%. Meanwhile, the fed funds futures market is pricing in a 50% probability of a rate cut by October. If that comes to bear, 1 year bills are attractive and should rally.
- The spread between highly-rated Commercial Paper (“CP”) and T-Bills is at a historic low. There are substantial supply/demand issues at work; CP outstanding balances has hovered right around $1 trillion since 2010, even though nominal GDP is up 42% in that period. Strong corporate cashflow has reduced the need for short-dated funding. Meanwhile, CP demand has been growing; prime money market funds, which shrunk in 2016 from $1.6 trillion to $545 billion due to money market reform, have grown 78% since the bottom. Meanwhile, T-Bill issuance knows no limits; out standings are up 31% since 2010, and supply is growing with the federal deficits. Could CP yield eventually less than T-Bills based on these supply/demand imbalances? We’ll see.
- While corporations are funding at attractive levels versus the U.S. Government, not so for broker-dealers. Repurchase agreements (“repo”) are the primary mechanism for non-bank financial institutions (like broker-dealers) to finance their trading positions. Repos are short term borrowing (mainly 1-7 days but as long as one year), are over-collateralized by a variety of assets (mainly Treasury securities), and trade at very different levels based on borrower. Display 1 only shows the rate for overnight repos collateralized by U.S. government bonds, which is generally what market participants refer to as the repo rate; in reality, this market ecosystem is much more robust.
For most of this decade, repo rates were below the Fed Funds rate. The Fed Funds market is an intra-bank, unsecured rate while the repo rate in Display 1 is secured by government securities. Broker-dealers are, unfortunately, facing the diminished capacity of the banking system to provide financing in the post Dodd-Frank world, pushing up repo rates. This is exacerbated by the recent Fed tightening, which has pushed up the Fed Funds Rate versus IOER as bank reserves have declined. Unfortunately, repo is difficult for retail investors to access; the easiest way is through money market funds, but the terms offered by these vehicles tend to be expensive.
Answers to our quiz:
- The most actively traded security in the global financial system is overnight government repo. Daily volumes in 2019 have averaged about $400 billion. By comparison, SPY, the S&P 500 Index ETF, has averaged about $22 billion in daily price volume (source DTCC, Bloomberg).
- Currently, the Fed owns about $375 billion U.S. T-Bills, while money market funds own over $1 trillion. Quantitative easing has bloated the Fed’s balance sheet with Treasury notes and bonds (source: New York Federal Reserve Bank).
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