Banks’ “reporting” dates are known inflection points in the short-term funding markets and typically fall at the end of the month, quarter, and of course the year. But periodically, the 15th of the month is also a pressure point. Such was the case this past Monday when a short-term funding rate that had been hovering around 2.21% soared as high as 10%.
The funding market succumbed to a trifecta of pressures:
- Payments on corporate taxes were due on 15 September, leading to high redemptions of more than $35 billion in money market funds.
- Cash balances increased by an additional $83 billion in the U.S. Treasury general account, which reduces excess reserves and simultaneously acts to reduce the aggregate supply of overnight liquidity available in funding markets.
- Dealers needed an additional $20 billion in funding to finance the settlement of recent scheduled U.S. Treasury issuance.
None of these pressures was extraordinary or unforeseen, but together they had an extraordinary impact.
At the source: the Fed’s lower reserves
In our view, the repurchase (repo) market, where banks and broker-dealers can obtain overnight collateralized loans from intermediaries, is a critical barometer of the health of the financial markets. This week’s events demonstrated that the funding markets overall are increasingly susceptible to large changes in flows from the supply side even if the demand for funding does not change much.
On September 15, as so many institutions needed funding, repo rates climbed well above the fed funds upper-end target at the time of 2.25% to briefly touch 5%. The following day, cash repo markets traded as high as 10% for those looking to finance agency mortgage positions overnight. Later that morning, the Federal Reserve Bank of New York acknowledged the pressures and conducted its first Open Market Operation (OMO) in more than a decade to add reserves to the funding markets that were clearly in need of the liquidity. Subsequently, after its meeting Wednesday, the Federal Open Market Committee (FOMC) announced a cut in the interest on excess reserves (IOER) of 0.30% – five basis points more than its cut in the fed funds rate – providing some relief to the upper bound of money-market yields. Even after this, however, funding costs have remained elevated, which suggests that additional steps are likely to be considered, including term funding facilities.
We expect these episodes of funding stresses to become more frequent with demand for funding and U.S. Treasury supply forecast to increase heading into year-end and the Fed’s reserve levels likely to drop further. Over the past two years as the Fed has undertaken “quantitative tightening,” its reserves have declined to $1.4 trillion from $2.3 trillion in August 2017.
Meanwhile, since June 2018, banks’ holdings of U.S. Treasuries have more than doubled to over $200 billion from $100 billion. These holdings have been financed by money market funds which have increased their repo investments by over $300 billion this year alone, based on data from the Investment Company Institute. While providing a timely source of funding that helps offset the increasing demand, this reliance leaves the U.S. funding markets more fragile if money market fund outflows occur.
What does it mean for investors?
We think investors should be prepared for deteriorating liquidity in the funding markets into year-end and the impact of this on the financial markets as a whole, with potential costs for levered strategies and risk assets in particular. While we expect that the Fed will continue to monitor these signals and ultimately take actions to help ease such pressures, there are seasonal and systemic factors that may continue to impact funding levels (in relative and absolute terms) for end users over the cyclical horizon. And as we saw in the fourth quarter last year and were reminded of this week, market conditions can change dramatically with little warning.
In reaction to these market changes, PIMCO has been actively evaluating and aiming to optimize client portfolios to either invest capital at these higher yields or minimize the funding costs by shifting to less impacted markets. From a broader investment perspective, market participants who have excess cash and can provide liquidity to the short-term funding markets may benefit. The front end of the yield curve and short-term cash markets – including repos – may offer attractive opportunities for risk-averse investors in the months ahead. For the past month, elevated repo rates combined with an inverted yield curve have provided investors with relatively high income potential and a low volatility profile. As the past few days have shown, current market liquidity conditions warrant defensive positioning overall but can also present opportunities for investors who are in a position to take them.
Jerome Schneider is PIMCO’s head of short-term portfolio management. William Martinez and Jerry Woytash are portfolio managers on the short-term desk.