Our analysts Vishy Tirupattur and Martin Tobias explain how the
announcement of new tariffs and the subsequent pause in their
implementation affected the bond market.
Read more insights from Morgan Stanley.
---- Transcript -----
Vishy Tirupattur: Welcome to Thoughts on
the Market. I am Vishy Tirupattur, Morgan Stanley's, Chief Fixed
Income Strategist.
Martin Tobias: And I'm Martin Tobias, from
the U.S. Interest Rate Strategy Team.
Vishy Tirupattur: Yesterday the U.S. stock
market shot up quite dramatically after President Trump paused
most tariffs for 90 days. But before that, there were some
stresses in the funding markets. So today we will dig into what
those stresses were, and what transpired, and what investors can
expect going forward.
It's Thursday, April 10th at 11:30am in New York.
President Trump's Liberation Day tariff announcements led to a
steep sell off in the global stock markets. Marty, before we dig
into that, can you give us some Funding Markets 101? We hear a
lot about terms like SOFR, effective fed funds rate, the spread
between the two. What are these things and why should we care
about this?
Martin Tobias: For starters, SOFR is the
secured overnight financing rate, and the effective fed funds
rate – EFFR – are both at the heart of funding markets.
Let's start with what our listeners are most likely familiar with
– the effective fed funds rate. It's the main policy rate of the
Federal Reserve. It's calculated as a volume weighted median of
overnight unsecured loans in the Fed funds market. But volume in
the Fed funds market has only averaged [$]95 billion per day over
the past year.
SOFR is the most important reference rate for market
participants. It's a broad measure of the cost to borrow cash
overnight, collateralized by Treasury securities. It's calculated
as a volume weighted median that covers three segments of the
repo market. Now SOFR volumes have averaged 2.2 trillion per day
over the past year.
Vishy Tirupattur: So, what you're telling
me, Marty, is that the, the difference between these two rates
really reflects how much liquidity stress is there, or the
expectations of the uncertainty of funding uncertainty that
exists in the market. Is that fair?
Martin Tobias: That's correct. And to do
this, investors look at futures contracts on fed funds and SOFR.
Now fed funds futures reflect market expectations for the Fed's
policy rate, SOFR futures reflect market expectations for the Fed
policy rate, and market expectations for funding conditions. So,
the difference or basis between the two contracts, isolates
market expectations for funding conditions.
Vishy Tirupattur: So, this basis that you
just described. What is the normal sense of this? Where [or] how
many basis points is the typical basis? Is it positive? Is it
negative?
Martin Tobias: In a normal environment over
the past three years when reserves were in Abundancy, the
three-month SOFR Fed funds Futures basis was positive 2 basis
points. This reflected SOFR to set 2 basis points below fed funds
on average over the next three months.
Vishy Tirupattur: So, what happened earlier
this week is – SOFR was setting above effective hedge advance
rate, implying…
Martin Tobias: Implying tighter funding
conditions.
Vishy Tirupattur: So, Marty, what actually
changed yesterday? How bad did it get and why did it get so bad?
Martin Tobias: So, three months SOR Fed
funds tightened all the way to -4 basis points. And we think this
was a reflection of investors’ increased demand for cash; whether
it was lending more securities outright in repo to raise cash, or
selling securities outright, or even not lending excess cash in
repo. This caused dealer balance sheets [to] become more
congested and contributed to higher SOFR rates.
Vishy Tirupattur: So, let's give some
context to our listeners. So, this is clearly not the first time
we've experienced stress in the funding markets. So, in previous
episodes – how far did it get and gimme some context.
Martin Tobias: Funding conditions did
indeed tighten this week, but the environment was far from true
funding stress like in 2019 and certain periods in 2020. Now, in
2019 when funding markets seized, and the Fed had to intervene
and inject liquidity, three months SOFR fed funds basis averaged
-9 basis points. And that compares to -4 basis points during the
peak macro uncertainty this week.
Vishy Tirupattur: So, Marty, what is your
assessment of the state of the funding markets right now?
Martin Tobias: Right. Funding conditions
have tightened, but I think the environment is far from true
funding stress. Thus far, the repricing has occurred because of a
higher floor for funding rates and not a scarcity of reserves in
the banking system.
Vishy Tirupattur: So, to summarize, so the
funding stress has been quite a bit earlier this week. Not as bad
as the worst conditions we saw say in 2019 or during the peak
COVID periods in 2020. but still pretty bad. And relative to how
bad it got, today we are slightly better than what we were two
days ago. Is that a fair description?
Martin Tobias: Yes. That's good. Now,
Vishy, what is your view on why the longer end of the bond market
sold off.
Vishy Tirupattur: So longer end bond
markets, as you know, Marty, while safe from a credit risk
perspective, do have interest rate sensitivity. So, the longer
the bonds, the greater the interest rate sensitivity. So, in
periods of uncertainty, such as the ones we are in now, investors
prefer to be in ultra short-term funds or cash – to minimize that
interest rate sensitivity of their portfolios. So, what we saw
happening in some sense, we can call it dash for cash.
I think we both agree that this demand for safety will persist,
and we will continue to see inflows into money market funds,
which you covered in your research. So, your insights Marty will
be very helpful to clients as we navigate these choppy waters
going forward.
Thanks a lot, Marty, for joining this webcast today.
Martin Tobias: Great speaking with you,
Vishy,
Vishy Tirupattur: And thanks for listening.
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Disclaimer
Vishy Tirupattur: Yesterday all my troubles
were so far away. I believe in yesterday.
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