(Bloomberg) — “May you live in interesting times” is sometimes said to be an ancient Chinese curse.
Interesting things have certainly been happening in the underpinnings of global markets — things that either run counter to long-standing financial logic, or represent an unusual dislocation in the “normal” state of market affairs, or were once rare occurrences but have been happening with increasing frequency.
Here’s a rundown:
1. Negative swap spreads
What’s new, and negative, and makes no sense? Swap spreads below zero, of course.
While the term may mean little to your average retail investor, swap spreads have become the talk of financial markets in recent weeks as they plumb historic lows and seemingly defy market logic.
At issue is the fact that swap rates — or rates charged for interest rate swaps — have dipped below yields on equivalent U.S. Treasuries, indicating that investors are charging less to deal with banks and corporations than with the U.S. government. Such a thing should never happen, as U.S. Treasuries theoretically represent the “risk-free” rate. While swap rates are imbued with significant counterparty risk that should demand a premium.
That may have changed, however, as new financial market rules require interest rates to be run through central clearing houses, effectively stripping them of counterparty risk and leaving just a minimal funding component. At the same time, funding costs for U.S. Treasuries are said to have gone up due to a host of post-financial crisis rules that crimp bank balance sheets (more on this later) causing costs to go up.
“The people who can arbitrage it away, their costs just went up a whole lot,” Amrut Nashikkar, a Barclays analyst, said in an interview. “We wouldn’t expect a dramatic reversal in the moves,” he added.
2. Fractured repo rates
The repo market is the lubricant for the global financial system, allowing banks and investors to pawn their assets — typically U.S. Treasuries and other high-quality paper — in exchange for short-term financing.
While there used to be little distinction between the rates at which counterparties raised money against their U.S. Treasury collateral, there is now an increasing divergence. ”You no longer have a single repo rate,” Joseph Abate, Barclays analyst, said in an interview last week. “The market itself is fracturing.”
You can see the trend in the above charts. The first shows the rate for General Collateral Financing trades (GCF) vs. the Bank of New York Mellon triparty repo rate. The second shows the GCF repo rate minus the rate that money market funds earn on their own U.S. Treasury repos. All are slightly different repo constructs against the same collateral, yet the difference between the rates paid on each has been widening.
Abate argues that much of this has to do with new regulation that requires banks to hold more capital against all their assets, regardless of their riskiness. The so-called supplementary leverage ratio makes it more expensive for banks to facilitate repo trades, placing more emphasis on quality of the counterparty and leading to ructions in rates. That is especially true at the end of financial quarters, when banks are encouraged to limit their leverage and “window dress” their balance sheets ahead of investor scrutiny.
This odd occurrence might not mean much for markets right now, but it could come into play when the Federal Reserve finally moves to raise interest rates. Much of the central bank’s exit policy will rely on using a new overnight repo facility to withdraw excess liquidity from the financial system. “At a minimum, analysts and the Fed may need to be more precise when they refer to repo and fed funds,” Abate said.
3. Corporate bond inventories below zero
Analysts at Goldman Sachs made waves this week when they highlighted the fact that inventories of some corporate bonds held by big dealer-banks had gone negative for the first time since the Federal Reserve began collecting such data. That means big banks are now net short corporate bonds with a maturity greater than 12 months equivalent to $1.4 billion, bucking the longer-term trend of net positive positions.
The record-breaking event revived a flurry of concerns about so-called liquidity, or ease of trading, in the $8.1 trillion corporate bond market. Similar to the repo market, a confluence of new rules is said to have made it more difficult for banks to hold corporate bonds on their balance sheets. At the same time, years of low interest rates have encouraged investors to herd into corporate bonds and hold onto them tightly.
That has worried some people who fear a lack of liquidity could worsen turmoil in the market, especially if interest rates rise.
“I was somewhat of a contrarian about the liquidity worries, but the evidence is starting to pile up,” Charles Himmelberg, the Goldman analyst, told Bloomberg. “The trend reflects the rising cost of holding corporate-bond positions. This looks increasingly like a growing headwind that will be with us for some time.”
4. Synthetic credit is trading tighter than cash credit
Meghan Trainor may be “all about that bass,” but market participants are squarely focused on that basis.