What is ACTUALLY going on in the repo market?

Dissecting what’s going on in the repo markets

There are two sides to every deal. The repo markets are no different.

On one side of the deal, there are banks sitting on a large supply of cash. On the other side of the deal, there are the hedge funds that are sitting on a large supply of Treasuries.

Banks lend cash to hedge funds and hedge funds place Treasuries as collateral to banks. Hedge funds are able lever up trades they make on Treasuries.

How do they do it?

One increasingly popular hedge fund strategy involves buying US Treasuries while selling equivalent derivatives contracts such as interest rate futures, and then pocketing the difference. This is an arbitrage strategy that hedge funds use that would generally yield small profits.

The trade is not profitable on its own, given the close relationship and price between the two sides of the trade. Hedge funds use leverage via the repo markets to increase returns.

In some cases, hedge funds take those Treasury securities they own, and place it as collateral in the repo market for cash. Those hedge funds then use that cash to increase the size of their trade and buy more Treasuries, and place it as collateral in repo market for cash once again. This process can be repeated over and over to leverage off the potential returns of this trade.

The arbitrage strategy above was once popular amongst dealer banks themselves. However, higher capital charges have led to their displacement by hedge funds, due to hedge funds greater ability to take on the risk of this trade.

There has been a growing clout of hedge funds in repo market, including Millennium, Citadel, and Point 42, which are very active in repo market and are also the most highly leveraged multi-strategy funds in the world.

So what really happened in September 2019 in the repo market?

This brings us to the market on September 16, 2019. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points).

The repo rate reached as high as 10% that day.

sept repo

Some have speculated that end of quarter pressures put on banks to meet those regulatory guidelines caused the repo spike.

However, you have to consider that these overnight funding Market issues arose in mid-September. Not at the end of September when you would expect banks to hoard more cash.

What happened in August and September that could have caused issues in the repo Market that rippled through hedge funds?

We turn our attention to Treasuries and their performance in August and September.

From July 31st 2019 to August 15th 2019 TLT (20+ year Treasury Bond ETF) increased almost 13%. This was following the Fed’s first-rate cut after the tightening cycle that we saw ultimately in December 2018.

tlt prices

The Fed cut the rate 25 basis points and the Treasury market responded with an outsized move on Long-Term Treasuries in anticipation more easy money Fed policies becoming a mainstay. The Fed reiterated that the rate-cut was a “mid-cycle adjustment”, but that didn’t stop Long-Term Treasury prices from surging.

From September 5th to September 13th the same Long-Term Treasury bond prices dropped 7%. This could be due to the fact that investors realized they over adjusted the price of long-term treasuries and were now adjusting prices down to reflect new expectations.

I believe much of the volatility in the overnight repo markets has to do with these large moves in Treasuries, which increased volatility in any trade related to Treasuries, which in turn would have an effect on leveraged trades made by hedge funds on Treasuries. Banks may have recognized this, and grew reluctant to provide cash funding to this market for this and other regulator reasons.

There is still a lot of research and learning I need to do on this, but these are my thoughts on the repo markets as of January 20, 2020. Please share your insights in the comments below.

The Federal Reserve is telling us there’s something wrong with hedge funds

Wall St Journal (Paywall)

One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market’s clearinghouse, the Fixed Income Clearing Corp., or FICC.

Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations—repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower’s default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.

The Fed’s aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September’s volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.

With the Fed acting as a backstop to hedge funds, is this admitting failure in the repo market with repo operations? Maybe failure is a strong word. Let’s say that repo operations have been less effective at diffusing money market issues than they Fed anticipated?

Did the Fed believe these funding issues would go away after year-end, only to discover these issues aren’t going anywhere anytime soon?

This is an interesting development that I post about more in the days to come.

Update: Follow-up post here – What is ACTUALLY going on in the repo market?

Why are some banks blaming regulations on the spike in the repo market?

Back on December 31, 2018 (before our September 2019 repo blowup) the rate on “general collateral” overnight repurchase agreements (repo rate) went from from 2.56 per cent to 6.125 per cent. This was the highest repo rate observed since 2001 and was the single largest percentage jump since at least 1998.

Some (including JP Morgan Chief Jaime Dimon) believe that various regulatory measures introduced in the wake of the Lehman crisis designed to make the financial system safer ends up putting stress on banks at quarter-end and moreso at year-end.

What regulations are said to cause stress in the repo markets?

The Basel III regulatory framework, calculates a tiered capital surcharge on global systemically important banks (GSIB) and is based on factors like their geographical sprawl, complexity and absolute size.

These charges are calculated from a snapshot at the end of the year which means that the world’s biggest banks (JPMorgan Chase, Citigroup and Bank of America) are motivated to deflate the size of their overall balance sheet and trading book ahead of the end of every year, and then reflate them again afterwards.

This allows banks to essentially operate with less capital, boosting returns to shareholders in the form of stock buybacks and dividends.

Some believed that the spike in repo rates in December 2018 suggests that big banks were wary of playing their usual role in facilitating markets this year feeding the turbulence in the repo markets,

In mid-December 2018, the Basel Committee on Banking Supervision opened up a consultation on whether it should revise its quarterly assessment of balance sheets, noting that “heightened volatility in various segments of money markets and derivatives markets around key reference dates (eg quarter-end dates) has alerted the Basel Committee to potential regulatory arbitrage by banks”.

Some argued that regulators could also easily tweak the impact by calculating daily averages rather than using a snapshot, and move to a smoother sliding scale of capital ratios as opposed to the current tiered approach that encourages gaming.

Changes have not been made to these regulations however, and the repo market continues to wreak havoc on Fed policy as of January 2020.

What are Federal Reserve repo operations?

Repo operations (within the context of the Federal Reserve) are Repurchase agreements and are conducted only with primary dealers.

The Fed purchases Treasury, agency debt, or agency mortgage-backed securities from a counterparty, subject to an agreement to resell the securities at a later time.

It’s similar to having a loan that is collateralized with assets. These assets from the banks have a higher value than the loan to protect the Fed against market and credit risk.

Repo transaction temporarily increase the quantity of reserves in the banking system.

The New York Fed began conducting repo operations in September 2019 to ensure supply of reserves is ample and to mitigate risks of money market pressures near year-end that could affect policy implementation of interest rates.

What is a repo?

Repo is a generic name for repurchase transactions (which can include buying or selling). It is a transaction in which one party sells an asset (such as Treasury Bonds) to another party at a set price and commits to repurchase the same assets from the same party at some future date.

If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss. This is what makes a repo very similar to a collateralized or secured deposit.

How is repo rate determined?

The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.

Why are repurchase agreements (repos) used?

Repurchase agreements can serve four different functions for various market participants:

They are a safe investment
Borrowing costs on repos are very cheap
Yields can be enhanced for those holding a large amount of safer assets
They provides a means for short-selling and short-covering

It’s safe because the cash is secured by collateral, which is generally safe assets. Makes it easy for seller of repo to make money back by selling those secured assets.

Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.

Why do banks use repos?

Banks will use repurchase agreements (repos) for short-term borrowing. They do this to raise short-term capital and generally use agreements which are very short-term, generally overnight or 48 hours.

The implicit interest rates on these agreements is known as the repo rate, and is a proxy for the overnight risk-free rate.

Repo can be used for many purposes. One such purpose would be as an efficient source of short-term funding

It also allows institutional investors to meet liquidity requirements without having to liquidate long-term investments. The repo market has become an important source of cash for non-banks to meet Basel regulatory requirements.

Did the Federal Reserve Kill the Volatility Trade?

On October 11, 2019, the Federal Reserve announced they would begin buying Treasury Bills in an effort to ensure there are “ample reserves” in the banking system through the end of the year.

fed treasury oct 11

On October 11, 2019, the Volatility Index (VIX) sat at 17.4. Today on November 26, 2019 the VIX has recently closed at 11.5. As you can see from below, it appears as though this not-QE program that is “organically” growing the Federal Reserve’s balance sheet has effectively killed the long VIX trade.

fed vix chart

The case made that supports this idea is that investors are engaging in more risk on behavior, because they are basing their decisions based on the Federal Reserve’s prior balance sheet expansion programs (QE 1-3).

Because the Fed is purchasing T-bills, they have eased some of the money market pressures. Liquidity in the market has proven to be a positive catalyst to the market.

Why do I believe this?

It can’t be the trade deal.

That’s the only other source that has been moving the markets higher according to many daily stock market new reporters. And I don’t believe these markets are pushing higher on hopes of a trade deal.

I think the Fed’s easy money policies have once again eased tensions. For now.

A lesson to me

This whole scenario has taught me a valuable lesson about position sizing. I’ve learned to not be so overconfident in my predictions.

Every trade made is a small bet. Each bet will abide by the Kelly criterion.

Never go all in.

Grow your money slowly and strategically.

Live to trade another day.

Read

Barton_options on Twitter has been a great resource for me to learn more about the Federal Reserve operations and how it relates to the Treasury and the overall economy.

He recently wrote about this in a newsletter you can read here.

FOMC Meetings and Market Behavior

Last December I learned a valuable lesson: be cautious around Fed meetings.

I remember seeing the market sell off. VIX jumped through the roof.

To me it was obvious that the Fed was going to hike rates. They said they would hike rates, markets were sold off, but not so oversold where the Fed was concerned about backing off the rate hike plan.

Then the market sold off. I thought it was crazy. I thought people had already priced in these Fed expectations. I was wrong.

When a similar situation took place in March, I realized that Fed days bring volatility. Why? Investors are obsessed with interest rates and Fed policies. The world’s central banks, led by the Fed, have babied along this 10 year bull market all along the way.

Zero-interest rate policies, quantitative easing, and easy monetary policies have all propped up this market in an effort to combat deflation.

Investors need the Fed to keep the market afloat. The game has changed, and this is what investors rely on.

Fed meetings solidify estimates that markets have priced in, or they rock the boat even more when estimates were not priced in. Then investors move on to speculation about the next Fed meeting. And thus the cycle continues.

Why should you expect market volatility to rise in the coming days?

Whenever the Federal Reserve holds a meeting, markets are on edge.

So many investment models must take into account risk-free discount rates, those rates based off Federal Reserve policies. As a result, pricing adjustments always take place around important Federal Reserve meetings.

Investors adjust those models based off what they believe discount rates will be in the future. This month, many investors have priced in a rate cut.

Speculation

If the Federal Reserve doesn’t cut rates I think the market will be disappointed and will sell off.

If the Federal Reserve does cut rates, I think the market will be optimistic (more than they already are), stocks will get a boost, and treasuries and gold will surge.

I don’t believe volatility will stay low this week. VIX is sitting at 13.2 as of now just before market open on July 23rd 2019.

In July, VIX bottomed out around 12.4. It’s bounced off this support line a couple of times this month. It’s surged over 14.5 on a couple of occasions. I think following the Federal Reserve meeting VIX will climb up to 15 or possibly over 17 by the end of the week.

That’s what I think. How about you?

What is the Federal Reserve going to do with interest rates this month?

There’s been much speculation among market participants about what the Federal Reserve will do with interest rates.

Many investors are pricing in the belief that the Federal Reserve is poised to cut interest rates for the first time in over a decade. The speculation hasn’t been about whether there will be a cut, but rather whether the cut is going to be 50 basis points or 25 basis points.

Debacle

James Bullard, President of the Federal Reserve Bank of St. Louis said he would like to cut by 25 basis points at the upcoming meeting.

This came after John Williams, President of the Federal Reserve Bank of New York said the Fed should “take swift action when faced with adverse economic conditions”. This led to much speculation and market positioning that bet on the FED cutting rates by half a point at the end of the month.

A spokesperson had to clear things up for Williams, and stated that he was making an “academic argument”, and NOT talking about the Federal Open Market Committee and their plans for the two-day meeting on July 30th and 31st at the end of this month.

JP

Federal Reserve board chair Jerome Powell has faced harsh criticism from Donald Trump. Trump’s relentless on Twitter about the Federal Reserve and the decision to hike rates in recent years.

He’s been critical of Powell and the Federal Reserve for not cutting rates while central banks across the world are cutting their own interest rates and engaging in other monetary stimulus.

Trump believes that if the Federal Reserve Cuts rates the US will continue to grow and reduce their debt burdens.

Respect

Personally, I believe Jerome Powell has handled the criticism from the President fairly well. I believe he’s done a good job (since December) at communicating the Federal Reserve’s expectations and focus going forward. I don’t know if it’s a popular opinion, but I like Jerome Powell.

He hasn’t caved to Trump, at a time when other individuals have made pathetic attempts trying to appeal to Trump through the media, in an effort to get a position with the Federal Reserve. And I respect that of Powell.

Why Cut?

]Economic numbers have actually been decent in the most recent reporting month. Retail sales rose by 0.4% in June which topped a 0.1% expected gain. On a year-over-year basis, sales increase 3.4%. From a consumer perspective things are still looking pretty good.

What about in job growth?

In June, non-farm payrolls rose 224,000, which was well above market expectations of 165,000. Unemployment rate edged a little bit higher to 3.7%, but is still sitting near 50-year lows. Wage growth was 3.1% year-over-year, one tenth of a point below Market expectations.

Trump continues to tout how great the economy is, but then he wants the Federal Reserve to engage and easy monetary policies which are generally reserved for times where markets are shifting tides.

Trump is trying to toe a line here and all he wants to do is have somebody to blame if the market does go to shit before the next election.

My Predition

I don’t believe the Federal Reserve is going to cut interest rates next week. I think the stock market will sell off. I think gold and treasuries will sell off.

Many investors have priced in a rate cut already, and they are preparing themselves for a potential devaluation of the US currency. If the Federal Reserve doesn’t cut rates, those three things will likely be going down.

Following all this volatility, the Fed will cut rates by 50 basis points in September. That’s my prediction and I’m going with it. What do you think?

What is the next catalyst that will move the stock market?

This week in the stock market has been a very slow news week.

We had a big news story with Boeing’s new 737 Max 8 crashing for the second time in six months. As a result numerous countries have grounded the 737 Max as a precautionary measure.

Also in this week’s news, Jerome Powell, Chairman of the Federal Reserve, spoke to 60 Minutes on Sunday evening to discuss the Federal Reserve policies and the current state of the economy.

With the exception of these two news stories, there hasn’t been a ton of newsworthy items this week.

What happened to a China Trade deal?

One of the most popular news stories from past two months was the promise of a China trade deal. If you look at this week’s headlines, there is little to no new information about a trade deal. This makes me believe we’re not going to have a China trade deal anytime in the next month or two.

So, with a slow news week it seems as though investors are waiting for some catalyst to move the market in one direction or another. Today, the S&P 500 Index touched the $2817 price level for the first time since October. I see the S&P 500 Index hovering around this level and continuing to consolidate within the $2780 to $2820 for the time being.

So with all of that in mind, what’s going to be the next Catalyst in the market? Which way is the market headed next?

Potentially positive catalysts for the stock market

Favorable trade deal for the US with China

If we are able to come to a trade deal agreement with China that is favorable to the United States, that would be great for our stock market.

For a trade deal with China to be favorable to the US it would need to protect our intellectual property rights and would also have some sort of a trigger for automatic tariffs if the Chinese don’t comply with the agreement. This would be the absolute best case scenario for the United States.

However I don’t think an agreement like this will come to be anytime soon. Xi Jinping, President of the People’s Republic of China, wants to maintain an appearance of strength for China. For this reason, I don’t think they’re going to make any concessions to United States any time soon.

According to Robert Lighthizer, we’re still a ways off when it comes to a favorable trade deal for the US.

Better than expected earnings

The second potential positive catalyst would be a positive earnings cycle in the first quarter of 2019.

Fourth quarter earnings from 2018 turned out to be better than expected and I believe this gave investors some confidence to continue to ride the market up in January and February.

If first quarter earnings are better than expected in the market this could be a positive catalyst for the market as well. It’s possible first quarter earnings go well, as some of the economic numbers we’ve seen are not quite as disappointing as expected, namely fourth quarter GDP growth, suggesting that perhaps Wall Street overreacted to slowing growthg. The worst economic numbers we’ve seen thus far of those of the non-farm payrolls added in February.

Personally I’m not too optimistic of either of these two scenarios playing out.

Potentially negative catalysts for the stock market

Worse than expected earnings

The first potentially negative catalyst would be if companies have worse than expected earnings in the first quarter. If we see earnings numbers come in below expectations this would likely drag the mark down.

Earnings estimates for the first quarter have declined for the S&P 500 as a whole, with estimated earnings for the index at -3.4% as compared to the previous year. In addition, there have been 76 companies in the S&P 500 Index that have issued negative EPS guidance as compared to 22 companies issuing positive EPS guidance. (Only 103 companies in the S&P 500 have issued guidance).

It’s important to pay attention not just to EPS results, but to the guidance we get from companies going forward into the second and third quarters of 2019.

Trade talks sour, and the US slaps more tariffs on China

Another potentially negative catalyst could be if the United States growing frustrated with the negotiations with China and decides to raise tariffs. Remember that President Trump delayed automatic tariff increases that were scheduled to kick in on March 1, 2019.

If this were to happen, it’s very likely China would raise their tariffs on American products as well. Much of this has to do with how well the negotiations go and if the two sides can at least agree on some sort of a framework of a trade deal moving forward.

Economic data is disappointing

A third catalyst would be if economic data continues to point to negative growth and growing in unemployment. If we begin seeing unemployment numbers rise, that could spook investors as rising unemployment tends to be an indicator of potential stresses in the economy.

In addition, the Federal Reserve Bank of Atlanta projects first quarter GDP to come in under 0.5%, which surely would be negative for investors.

Federal reserve raises interest rates

Finally, a fourth catalyst could be if the Federal Reserve does decide to raise interest rates this year. As I mentioned in my previous article, many investors are pricing in a rate cut this year.

If the Federal Reserve decides to raise interest rates, it would be due to the threat of inflation in the economy while unemployment rates remain low.

Conclusion

Overall, I believe the potentially negative catalysts are more likely to occur and impact the market. I believe that we’re going to see a downside move within a month or two, given that the recent market rally has been a little too hot in the current global economic backdrop.

However, it’s not outside the realm of possibility that we get positive news that could drive the market to all time highs before beginning to hit some resistance.

These are just a few of my thoughts on what I believe could impact the market moving forward. What catalysts are you watching out for in the market?

What has caused the market to rally from December through today? (It’s not the promise of a China trade deal)

If you’ve been paying attention to the stock market since the Christmas Eve bear market, the S&P 500 is up 19.5%. Much of this rally has taken place in January and February 2019. If you’ve been reading the news headlines, a lot of the rally was contributed to the promise of a China trade deal. In my opinion these news headlines are wrong. Let me explain why.

Enter the Federal Reserve

Investors have a tendency to pay very close attention to the actions of the Federal Reserve board. If you’re not familiar, the Federal Reserve primarily has the task of influencing interest rates.

To illustrate this point, look at how the market reacted in the times where Jerome Powell discussed the interest rate policies of the Federal Reserve.

On October 3rd an article by CNBC, Powell said we were a long way from a neutral on interest rates. This was an indication that more rate hikes were to come.

Jerome Powell said that interest rates were extremely accommodative and that this was necessary when the economy was weak. We no longer needed low interest rates anymore. He went on to say that interest rates were still accommodative but they were moving to a place where they can finally be neutral.

What happened next?

Following these comments by Jerome Powell we saw the S&P 500 index drop through the month of October (see the red arrow above). The S&P 500 continue to experience high volatility through November and into December.

Interest rate policy uncertainty

There was a lot of fear in the market when it came to the interest rate policies of the Federal Reserve. The Federal Reserve continued to hike interest rates in December which set off a wave of selling in the market.

From December 3rd until the low point on December 26th the market dropped 16.1% of its value. This came after a slight bounce back in November following Black Friday shopping.

Jerome Powell continued to say that interest rates needed to get back to neutral. He said that the Fed was relying on the data to tell them when to stop raising rates.

The language used by Jerome Powell scared the market because they believed that the Fed would continue to raise interest rates two or three times in 2019 along with the interest rate hike that they had just completed in December of 2018.

Fear and pressure from the President

A lot of investors took this language as being quote “hawkish”. What this means is that the Federal Reserve is using tighter monetary policy which would raise interest rates and help cool down the economy and keep inflation in check.

There was a lot of fear in the market in December and Donald Trump wasn’t a fan of Jerome Powell raising interest rates.

In my opinion I think Jerome Powell faced a lot of pressure from investors and our President to take a more neutral stance on interest rates. As a result the Federal Reserve went from being hawkish to what they called dovish.

For this reason I don’t believe that any of this rally has to do with a China trade deal. I think the rally from January until February and now going in March is entirely on the back of the Federal Reserve.

I believe that a lot of investors are pricing in an interest rate cut at some point in 2019.

The Fed’s dovish opinion on interest rates combined with short-side investors getting squeezed, algorithmic trading, day traders, have all contributed to this most recent market rally.

What comes next?

We are at a level in the market that we have struggled to get over time after time.

There seems to be a lid on the value of the S&P 500 Index around 2,800 to 2820 price level. We’ve touched this price level multiple times and have only broken through the level one time since last February, when the market rallied over the summer.

It will be interesting to see how the market plays out over the next few weeks. I believe many investors have priced in the Federal Reserve decreasing interest rates at some point in 2019.

If the Federal Reserve decides increased interest rates one more time this year I think it could be extremely detrimental to the market and how they perceive things.

I don’t think an increase in interest rates should have such a drastic effect on the market, but because investors are expecting expecting a cut in interest rates instead of an increase, this could set off some pretty drastic, expected action in the market.

I believe that Jerome Powell wants to continue raising interest rates and try to get back to a more neutral level, I just don’t know if the political pressure will allow him to do so.

The case for raising interest rates is to allow the Fed some more room to cut interest rates if and when we do eventually enter into a recession in 2020 or 2021.

Conclusion: Don’t pay too much attention to headlines

Don’t believe what you see in the news. I don’t believe the market is rallying on the back of a China trade deal. I don’t think the market believes we’re going to get a China trade deal in the next two months.

I think the market is hyper focused on the behavior of the Federal Reserve and that has caused much of the volatility from October through December, and the Federal Reserve’s complete 180 on interest rate policy has also caused the market rally up to this point in 2019.