Front end dynamics matter more than you think

The first half of 2018 has seen an oversupply of front end paper. Bills  issuance will reach 400bn this year, Bills are now the effective floor for rates markets.

We are also seeing an oversupply of FHLB loans which lately are the largest provider of collateral for banks HQLA (High Quality Liquid Assets).

Foreign central banks are using the Fed foreign repo pool on a larger scale as US commercial banks are pushing away non-operating deposits from CB and corporates (Due to ratios and balance sheet constraints). 

The Fed helped uncapping foreign repo pools. The Fed also returns cash by 830 am vs 330pm for tri-party repo. Foreign repo grew to about 250bn.

Repo rate are now printing above IOR (Interest on Reserves at the Fed) and fed funds are following through.

The demand side of the equation is also disrupted as CFOs react to repatriation and BEAT policies, they also have access to more agency floater reducing the need for Bills at a time when the treasury is floading the market.

More sophisticated investor have been playing the cross currency arb, investing in foreign money market.

Higher Libor, triparty repo rate is costly for the inter dealer market and the Relative Value community.

Now that repo is above funds rate, FHLB are lending in repo market and less in the fed fund market, weakening the latter.

The traditional arb [o/n fed fund – IOR] from foreign banks is not en vogue anymore, it’s more about settlement risk and balance sheet constraints, LCR (Liquidity cover ratio) nowadays.

Japanese MOF through Japanese banks in the US has also floaded the market with collateral.

Dealers took the Treasuries they borrowed from the MoF and pledged it in the o/n repo market in New York and then took the cash and lent it in the FX swap market to meet the hedging needs of life insurers and regional banks.

Ninja Bills and synthetic bills are the new rage.

$1 trillion in synthetic Treasury bills are issued every three months in Tokyo alone – about $400 billion more than just three years ago according to Credit Suisse.

Exposure to Japanese lifers is mounting (Some regulators are getting uncomfortable).

Policymakers in Japan and Europe have been proactively trying to reduce the reinvestment drag for non-bank lenders of dollars in FX swaps. The less the drag, the better the spread of synthetic bills over Treasury bills, the more dollars are being lent via matched FX swap books and the less the pressure on cross-currency bases to Libor.

As Pozsar would frame it: “We are swimming in safe assets and by adding to the supply by issuing more bills, we are making it more expensive for the rest of the world to buy dollar assets on a hedged basis. As a borrower nation, we need the foreign marginal buyer and we should not make their hedging costs higher than necessary by issuing more bills.”

No wonder rates have had no difficulty going higher, FED wind in your sail, carry in your favor, double whammy for treasuries.

In previous post you can see that treasuries at 3% are not as attractive to foreigners once you hedge the FX component. 

Understanding front end dynamics is more often than not a key factor to fixed income returns.

Now if summer 2018 brings more volatility, a flight to quality might bring buyers anticipating capital gains.