(Bloomberg) -- Traders are rushing to the US funding markets, lifting financing costs to concerning levels with a little more than a month left in 2024.
The rate on overnight general collateral repurchase agreements for year-end — or loans collateralized by Treasuries — and those backed by mortgage-backed securities are soaring. The spike has some on Wall Street preparing for even more volatility as year-end regulatory burdens drives some of the largest participants to the sidelines of the repo market.
This is the first time in years when worries about the turn of the year “have started to get priced in so early,” said Jan Nevruzi, a US rates strategist at TD Securities. “Clearly there are bottlenecks that will get worse with year end.”
Trading in overnight repo for the Dec. 31 to Jan. 2 period traded as high as 5.60% last week and has since retreated to 5.45%, according to Curvature Securities. That’s up from 4.85% earlier in the month. At the same time, repo backed by mortgage-backed securities rose to 5.69% on Wednesday, higher than where it traded on Nov. 15, 5.65%/5.55%.
By comparison, overnight general collateral first traded around 4.61% on Thursday, according to ICAP, which is where it’s been opening this week.
While a spike in repo rates on the final trading day of September stemmed more from primary dealers’ balance-sheet congestion instead of the Federal Reserve’s ongoing quantitative tightening, there are concerns the overnight funding market will be more volatile given even more stringent constraints at the end of the year. These include an estimated $147 billion of Treasury auction settlements on Dec. 31 — about 25% larger than ones on Sept. 30 — and banks paring repo trading in order to tidy up their balance sheets for the year-end regulatory snapshot.
“Dealer balance sheets today are quite full,” said Mark Cabana, head of US interest rates strategy at Bank of America Corp., at the New York Fed’s FX Market Structure Conference on Tuesday. “We typically see it at end of year but we’re seeing pockets of dealer intermediation challenges in areas where we haven’t seen things this acute.”
Then there’s the additional demand for repo collateralized by equities that’s further contributing to market strains. The amount of equity collateral that dealers need to finance repo has also swelled, driven by the benchmark S&P 500 Index rallying to new highs this year and robust investor demand for leverage equity exposure, according to JPMorgan Chase & Co. As a result, the total amount of primary-dealer equity financing repo is just off the highest level since April 2013, according to the most recent Federal Reserve Bank of New York data.
“There’s just too much collateral, too much demand to take equity risk, too much leverage,” Cabana said. “Just as there’s more collateral that’s added to the system, there’s less liquidity.”
Dealers are likely to rely more on sponsored repo, which allows lenders to transact with counterparties like money-market funds and hedge funds, without bumping up against regulatory constraints. These agreements are effectively “sponsored” or cleared via the Fixed Income Clearing Corp.’s platform, thereby allowing dealer-banks to net two sides of a trade and hold less capital against it.
Sponsored repo activity totaled about $1.8 trillion as of Sept. 30, Depository Trust and Clearing Corp. data show. It was $1.58 trillion as of Nov. 20.
Furthermore, it looks like the funding markets won’t be able to rely on a key Fed backstop — the Standing Repo Facility, or SRF— to support it through the end of the year. SRFs provide eligible banks and primary dealers repo financing at rates set by the Fed to keep funding-market rates from moving outside of the central bank’s target range. But the facility’s relatively low use and inability to maintain rates at the end of the September revealed its limitations.
The program targets only a part of the broader repo market. Roberto Perli, manager of the System Open Market Account at the New York Fed, pointed out last week that SRF operates in uncleared client-to-dealer tri-party transactions, one of three segments in the space.
Barclays strategist Joseph Abate and TD’s Nevruzi said year-end pressure may be amplified due to the effects of bank share prices on risk scores for the global systemically important banks, or GSIBs, which have to tidy up their balance sheets for their end of the year capital requirement check-ups.
Still, stress in the funding markets mean that traders are likely moving early to get ahead of additional difficulties, according to John Canavan, an analyst at Oxford Economics.
“It’s so apparent that year-end risks are coming, my assumption is that most investors are going to try to get ahead of that risk,” Canavan said.
(Updates overnight repo levels for year-end in fourth paragraph and adds analyst comment beginning in penultimate paragraph.)
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