Dysfunctional Credit Markets – Still Waiting On The Fed

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As the week ended, U.S. credit markets appeared confused, if not outright dysfunctional. The 10-Year Treasury yield began February at 1.09% and reached an interim peak of 1.54% on February 25. Then it retreated to 1.42% as markets thought the rise had simply been overdone.

Source: Forbes

But Fed Chair Powell’s refusal to assure financial markets regarding the Fed’s intentions at the Wall Street Journal’s Jobs Summit (as detailed in last week’s blog) caused the 10-Year to spike again to 1.56% on Friday, March 5. Markets were steady most of last week as the RBA (Reserve Bank of Australia) and ECB (European Central Bank) announced new easing programs. But, on Friday (March 12), the 10-Year yield spiked again, this time by nearly 10 basis points (0.1 percentage points) to 1.625%. And, once again, the Fed was MIA.

It could be that the Fed is simply in its quiet period as the Federal Open Market Committee (FOMC) is scheduled to meet Tuesday and Wednesday (March 16-17). Surely, they can’t continue to allow the financial markets to continue to assume a tightening phase is approaching. Because Chair Powell doesn’t have the best track record for consistency, despite his having indicated several times that tightening is nowhere in sight, today’s financial markets need constant assurance. Hopefully, that comes in Wednesday’s FOMC statement and the follow-on press conference.

As indicated above, markets appear to be dysfunctional. Last week, the repo rate (the interest rate paid in the interbank market for reserves) had episodes where it was negative, i.e., the borrowing institution got paid to borrow instead of paying for funds! Fed silence on expiring capital rules was likely responsible for most of Friday’s 10 basis point rate spike.

Last April the Fed exempted banks from having to carry capital against their holdings of Treasury securities. That ends on March 31, and the Fed has been silent on whether-or-not it would extend the exemption. In all likelihood, it will. But, don’t forget that March 31 is also quarter end where these institutions must report their capital ratios both to the regulators and to the public (if publicly traded). 

As a result, as a hedge against the worst outcome, the primary bond dealers dumped more than $65 billion, or 25% of their Treasury holdings and banks sold an additional $38 billion. This, together with last week’s Treasury auctions and the signing of the $1.9 trillion “stimulus” bill (i.e., significantly more future borrowing) all came together at week’s end. 

The confluence of these events seems to be the immediate cause of the rate spike. Can rates rise further from here? That depends on the Fed. There may be some nervousness between now and Wednesday, but markets will know for sure when the FOMC statement is released and the follow-on press conference concludes.