We’re about to explore the Bermuda triangles of the market. So hang on tight.
There are….curious things happening in global markets – things that seem to fly in the face of traditional financial understanding. We delve into three of them and try to understand what’s going on underneath the underneath.
1. Corporate bond inventories are negative
There’s a lot of worry about corporate bond inventories, which have turned negative. See, the Federal Reserve trades securities directly with certain designated parties, called primary dealers. These primary dealers include banks and other broker-dealers and they act as market makers for the Fed, buying and selling securities and making them available to their clients.
So what’s the big deal about negative debt inventories? Well, while a negative level of debt is actually common for U.S. Treasuries (government bonds), this is the first time since we’ve been keeping data on this metric that corporate bond inventories have been below zero.
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This is the first time since we’ve been keeping records that the primary dealers are shorting corporate debt, or betting that prices of corporate bonds will fall. The price of holding corporate bonds is increasing and these influential dealers, as a unit, are saying, “We’d rather not hold corporate debt, thank you very much”. From a positive inventory of $13 billion, we have plunged to -$1.4 billion.
It doesn’t really qualify as a huge vote of confidence. It also means that people will start to worry about liquidity (how quickly they can convert their assets to more liquid ones). If the primary dealers are insinuating that prices will fall, then investors might rush to sell their debt, but if the biggest banks and brokers aren’t buying…then there could be trouble.
It’s weird because there’s decent demand right now, but maybe the market makers know something we don’t.
2. The Repo Market is on a Diet
If the global financial system is an engine, then the repo market’s the lubricant allowing it to run smoothly.
The repo market, or repurchase agreement market, allows investors to dump their assets in exchange for short-term loans, guaranteeing that money is available to those who need it most. Recently, however, it’s been in a bit of a bind.
In the past three years, repo borrowings have declined by an astonishing $650 billion, or nearly 25%. At the same time, the rates at which parties are offering money – which used to be basically indistinguishable from one another – are diverging. The market is splintering.
Repos are important because of the speed at which this market works. Agreements are often hammered out overnight and repos are a big source of day-to-day funding for banks and other players in the financial system. The fact is that new rules about the quality of debt banks can hold have made them reluctant to continue acting as the middleman on a huge portion of this market.
Because they have to be more careful about what debt they incur, they have to charge more interest, which is in turn choking the repo market. It may not be too much of an issue right now but remember that the economy is still at the mercy of the FED’s QE program. When the FED decides that it is time to raise rates, their actions will only serve to tighten the economy by removing the easy money from the system. When easy money leaves the system, investors tend to get more selective about the risks they take on and we could see the repo market shrink even more.
3. Negative Swap Spreads
Another thing that’s negative and makes no sense.
A swap spread rate basically measures the difference between some sort of risky security and a safer security – usually a U.S. government bond.
Usually you would expect that rate to be positive. U.S. bonds are considered the safest asset in the world. Negative rates mean that investors might consider corporate debt safer than U.S. Treasuries.
During the middle of the financial crisis, negative swap spreads were seen as anomalous – just a glitch in the matrix, but now it’s back and is more confounding than ever. Where in 2009 it was only the 30-year swap spread that was negative, today the phenomenon is occurring across the board.
There are a few explanations for why this might be happening. Some institutional investors believe that this is an after-effect of regulation after the Great Recession and could be related to the repo market.
Remember how we talked about the repo rates rising? As we mentioned before, banks have to now be more prudent about the type of debt they take on and because they’ve raised their prices (are charging more to be the middle man), the price of Treasuries have effectively gone up as a result.
There’s also been an increase in the amount of corporate debt being issued. When this happens, the swap spreads usually decline. Throw these two effects together and you get treasuries moving one way and corporate rates moving the other way – which combine to give us an overall negative swap spread.
These three instances of erratic market behavior all seem to indicate one thing: liquidity is drying up and people are starting to watch their money carefully. While there are some explanations for why these things are happening, no one’s 100% certain, they just know that something’s up.
It appears that the biggest players in financial markets are behaving like there’s not a whole lot of money out there. In fact, their actions seem to indicate that they believe they’re approaching the end of an economic cycle. We’ve had a very long bull market and clearly the anxieties of the Great Recession are still out there and manifesting themselves in odd ways throughout the market.
Meanwhile, the Fed is yet to raise rates, which should happen sometime during the middle of an economic cycle. We may be seeing two competing factors crash up against each other. Essentially, market participants who believe a down market is approaching are clashing against a central bank that they view is only going to make things harder on them.
The resulting market weirdness could just be a symptom of this underlying friction.