Follow the Money

This is a guest blog by Josh Younger, an interest rate strategist at J.P. Morgan. Joshua Younger is employed by the Research Department of J.P. Morgan Chase & Co. All views expressed in this forum are his own and may not align with those of the firm, but they are consistent with all research publications published under the firm brand for which he is listed as an author. This is the concluding post in a three part series.  By the middle of March, the train is really threatening to jump the track. As we discussed in Part I, a rapidly shifted fundamental backdrop had precipitated a collapse in market depth and severe liquidity tiering among fixed income products. In Part II, we described how this combined with operational risk concerns shook loose a $200-300bn, highly levered position that had mostly been accumulated as a placeholder. As dealers were forced to take on more and more inventory, the Treasury market became increasingly incapable of intermediating even modest transactions. For this last segment, it is important to bear in mind that Treasury cash/futures basis unwinds were arguably the more acutely concerning symptom of a much broader problem. A sudden and fast-moving economic shock of unknown but clearly massive proportions created a rush to hoard cash to better weather the storm. Individuals started to stockpile physical cash: Fed data shows that currency in circulation grew 6 percent in March and April, or roughly six times its longer-term growth rate. But, the actions of large institutions and even governments had much larger consequences. Non-financial corporates, for example, drew more as much as $300bn from their credit facilities at large commercial banks (based on Fed H.8 data) and redeemed more than $130bn of their prime money market fund holdings over the same period (comparable in pace and percentage to the weeks after the Lehman bankruptcy). U.S. Treasury data shows foreign central banks sold $128bn of assets as well, presumably to manage capital outflows and currency effects related to the pandemic. In all individuals and businesses were demanding $1tn in new cash and equivalents over just a few weeks (CHART 1). How were banks supposed to supply the liquidity the market was demanding? This is where two elements of the post-2008 regulatory framework started to conflict with each other, and inhibit the free flow of cash through the financial system. On the one hand, liquidity regulations, specifically the Liquidity Coverage Ratio (LCR), require banks to hold stocks of high-quality liquid assets (HQLA) that can be monetized quickly and at low cost should the need arise. On the other, capital regulations like the Supplementary Leverage Ratio (SLR) and surcharges on Global Systematically Important Banks (GSIBs), limit the size, complexity, interconnectedness, and cross-jurisdictional exposure of any given institution. In normal times, these two sets of rules can co-exist quite peacefully with each other. But when the rainy day comes, their interaction can turn toxic. The central role and large market share held by bank-affiliated securities dealers meant that the banking system itself is largely responsible for the monetization of its own HQLA. In other words, when a bank is facing a spike in liquidity demand—including any of the sources listed above—it is other banks that intermediate asset sales, especially Treasuries, to source the necessary cash. As a result, when leverage and other constraints inhibit their ability to do so, as was certainly the case in March, banks can no longer monetize their HQLA at a reasonable cost—if they can do so at all. Other problems arise as a result of what happens to that liquidity. Draws on bank revolvers are particularly pernicious. By tapping these facilities, non-financial corporates are creating new assets (loans) and liabilities (wholesale deposits) on bank balance sheets. If the requisite transfers are funded by raising new capital, leverage can remain roughly the same. If banks rely on HQLA which largely remains in the banking system—e.g., reserves at the Fed, which are a closed system, or sales of Treasuries that linger in bank-affiliated dealer inventories, it can exacerbate the leverage problem that generated market dysfunction in the first place: a vicious cycle. Those new wholesale deposits posed another problem. Because they are being held ‘just in case’ rather than for everyday transactional activity, they are likely to be characterized as ‘non-operational’ for LCR purposes. That category of deposits is considered the highest run risk, and therefore assigned the most demanding coverage requirements. Thus, as liquidity demand spikes, the stock of HQLA banks are required to hold is increasing, not decreasing.  This is clear from 1Q 2020 regulatory disclosures, released a few months after the crisis. Liquidity Coverage Ratio weighted outflows, a measure of the HQLA required to satisfy regulatory minimums, were increasing rapidly at the same time as capital requirements related to total leverage and GSIB surcharges (CHART 2). When bank leverage is rising in this way, the most effective offset is shedding assets. Yet that was precisely the risk that regulators wanted to avoid. Disorderly delevering is manageable if it is isolated to a relatively narrow corner of the market (in this case, relative value hedge funds). But the same dynamic taking hold across the banking system was quite another thing. FRA/OIS and FX swaps, two common barometers of stress in the banking system, were flashing bright red within days (both are measures of how easily banks can raise funds). If things were allowed to continue along this path, fire sales of assets into a severely illiquid market risked a full-fledged panic and financial crisis in the midst of a historic economic shock. That is where the Fed comes in. Central banks control the money supply and issue the currency. If nothing else, this gives them the right set of tools to deal with a liquidity squeeze. Simply growing the monetary base could in principle supply the cash that the banking system could not. And grow it they did: the emergency cut announced on March 15 was paired with a commitment to purchase $700bn of Treasury and mortgage-backed securities, which was made unlimited shortly thereafter. After peaking around $75bn per day of Treasury purchases in the second half of March, their asset purchases slowed gradually to the current daily pace of roughly $4bn. The Fed also restarted the FX swap lines, re-introduced several 2008-vintage facilities authorized under Section 13(3) emergency lending powers, and introduced a suite of new facilities under the same authority. At the peak in early-June, the monetary base had increased more than $2.8tn (~13 percent of 1Q GDP) over just three months, the largest such expansion since Second World War (CHART 3). This intervention worked along a number of dimensions. Market depth in Treasuries bottomed out and transaction costs normalized as automated systems flicked back on, and futures quickly came back into alignment with their deliverable basket. Combining these elements, and some others, shows both how severely market functioning had broken down, and how rapidly it healed in the wake of this historic intervention (CHART 4). FRA/OIS and FX swap pricing also started to return to Earth, thanks in large part to the resuscitated swap lines as well as old (CPFF) and new (MMLF) 13(3) facilities. What does this tell us about the efficacy of the post-2008 bank regulatory regime? That suite of rules was arguably successful at transforming a credit crisis, which is quite difficult for central banks to solve, into a liquidity crisis, which is well within their wheelhouse. With market functioning back to something resembling ‘normal,’ and little sign of funding or credit market stress, they appear to have lived up to that assertion. In that sense, this is a success story. In another, however, we have simply substituted a fast-moving crisis for one which is slower moving. In aggressively expanding the monetary base, the Fed has mechanically increased the size and leverage of the banking system. Nearly $6tn of federal deficits over the next two fiscal years will likely compound the situation. In the 1940s, the last time such a thing happened, it took the banking system decades to delever as the post-War recovery drove renewed demand for private sector credit. With Supplementary Leverage Ratio and GSIB surcharges likely to become increasingly binding constraints on bank activity, the Fed risks simply delaying and spacing out, but not avoiding, asset sales and a sharp curtailment of credit. That brings us to the present day. There has been some effort to counteract the impact of rising banking system leverage with changes to some regulations. The Fed, FDIC, and OCC in particular have proposed temporarily excluding risk-free assets (cash and Treasuries) from the calculation of total leverage exposure when assessing Supplementary Leverage Ratio compliance. There are, however, significant gaps in this approach. As proposed, Supplementary Leverage Ratio relief comes with strings attached that may be difficult for many banks to accept. GSIB surcharges, which in practice are a strong constraint on bank behavior, are similarly implicated by a much larger Fed balance sheet but conspicuously absent from the discussion. Some other proposals, like a clearing mandate for the Treasury market, seek to reduce the intermediation frictions that generated this crisis without wholesale changes to the regulatory framework, but require quite a bit of further study and are unlikely to be a practical solution for some time. This all means the coming months will likely represent a balancing act, ensuring the safety and soundness of the banking system on the one hand, while seeking to minimize the financial stability risk associated with market dysfunction on the other. The only fundamental change is the Fed’s clear willingness to do what is needed when financial stability is threatened by these dynamics. Though things are calmer now, there is no way to rule out them being called upon to do so again.

This is a guest blog by Josh Younger, an interest rate strategist at J.P. Morgan. Joshua Younger is employed by the Research Department of J.P. Morgan Chase & Co. All views expressed in this forum are his own and may not align with those of the firm, but they are consistent with all research publications published under the firm brand for which he is listed as an author. This is part two of a three part series. In Part I of this series, we described how liquidity collapsed as markets were forced to rapidly come to grips with the economic implications of a global pandemic. That was arguably nothing new, however. Recent memory includes at least a few episodes: the 2008 financial crisis of course, several episodes related to the Euro crisis, the downgrade of the U.S. government’s credit rating, the ‘taper tantrum,’ the devaluation of the Chinese Yuan, Brexit, and the 2016 U.S. Presidential Election, just to name a few. Things really started to come apart this time around in a relatively obscure corner of financial markets. Hedge funds and other ‘sophisticated’ investors often hold short positions in futures (a contractual agreement to sell those bonds on some future date) against levered positions in the bonds they reference. Liquidity tiering among different fixed income instruments favored futures as the preferred hedging vehicle, leading to a widening price discrepancy between those contracts and the bonds in their deliverable basket. This had happened before, but there were a few key differences this time around. The net result threatened a new kind of financial crisis—one of collateral quantity rather than quality—which had the potential to be broader then the kind of disorderly systemic delevering policymakers had fought so hard to avoid in 2008. Why did these positions exist at all? Trading bonds versus futures has been at the core of relative value strategies in fixed income for decades. When prices on the futures are too high compared to the securities one can deliver, for example, there is money to be made in shorting the futures and buying securities—and vice versa when they were too low. This effectively enforces the tight theoretical relationship that should exist between these two connected instruments. Such trades were generally considered very low risk because losses should be limited; a short futures positions represents a committed buyer, and bonds can simply be delivered at the appointed time. Potential gains are small as well—only a few tenths of a percent. Thus, cash/futures basis trades tend to be very highly levered (20 or even 50 to 1, or more): securities are purchased using short-term borrowed funds for which they are pledged as collateral (repurchase agreements, or repos; often for no-money-down), and initial margin on the futures leg tends to be small (a few percent of notional, and potentially less if optimized against other positions). How large are these cash/futures positions? A full accounting is not possible with public data, but the impact can be seen in net positioning reports released by the CFTC. Gross short positions among ‘levered funds’ increased from less than $100bn in early-2010 to a peak of nearly $875bn in mid-2019 and still around $750-800bn to start this year (CHART 1). That this was related to basis trading is clear from the decoupling of positioning from economic exposure to moves in interest rates (CHART 2). In other words, hedge funds appeared to be accumulating larger and larger net short positions in futures even as their overall returns reflected a mix of net long and short exposure over time. This suggests another position that is not visible in the futures data—e.g., longs in securities, likely financed with repo. Why would this position grow so rapidly? If anything relative value opportunities were fewer and further between over the past ten years, in no small part due to the heavy involvement from the Fed. Rather than economic motivations, it had to do with shifting incentives imposed by new regulations. After the 2008 crisis, new rules put in place to address Too Big to Fail (TBTF) subsidized the social cost of size and complexity with capital surcharges that were agnostic to risk. Total leverage, for example, was measured capital against all assets, including Treasuries and cash. That made certain types of low-margin/low-risk transactions, like Treasury repo, potentially capital intensive. Banks responded by planning ahead, often offering repo to clients on a ‘use-it-or-lose-it’ basis. From the client perspective, that incentivized using their allocation without taking much market risk. Basis positions, with their repo-financed bond leg and theoretically limited downside, were ideal placeholders with which to maintain access to leverage in the event it was needed on some future date. Under normal circumstances, the dislocation in basis pricing that emerged in early March could be assumed to naturally resolve over time. The holders of these levered bond positions still had a committed buyer in the counterparty to their short futures contract. That is, if they could hold both legs until the delivery period. Hanging on was rapidly becoming far more complicated than anyone anticipated. As the pandemic accelerated and many dealers were forced to transition quickly to work-from-home arrangements, there was a risk that certain types of trades could get lost in the shuffle. Repo is particularly operationally intensive, and had suffered disruptions in the past (for example, September 2001). Hedge funds feared they could be forced out of basis trades early, and at a significant loss. Thus, focus shifted from managing market risk to managing operational risk. Even if in practice one thought that forced early unwinds were unlikely, the potential for others to come to that conclusion and unwind meant prices could become even more dislocated, and losses much larger. By mid-March, cash/futures basis pricing already implied 10-20 percent losses on some positions, and potentially more depending on the portfolio composition. The way things were going, it could have gotten much worse from there. For placeholders with little economic value, this was concerning to say the least. A classic run dynamic was taking hold. A full accounting of what came next is once again not possible with public data, but the evidence is clear. CFTC positioning data shows a roughly $200bn decline in gross short futures positions among levered funds in March and April. Over the same period, the Cayman Islands (a very common domicile for hedge funds) was a net seller of just over $200bn in Treasury securities YTD—a more than 4-sigma event—despite the fact that prices were rising rapidly (CHART 3). Margin calls likely accelerated this process: in late-March, the Chicago Mercantile Exchange (CME; the clearinghouse for Treasury futures) increased the funds required to maintain existing futures positions, forcing hedge funds and others to come up with as much as $75bn in additional cash in just a couple of days (CHART 4; also discussed here). Though futures can be collapsed in an unwind—a short paired with a long position in the same contract becomes no position at all—securities always end up on someone’s balance sheet. In an ideal world, market makers would be pure intermediaries, lining up buyers and sellers in advance. When a match cannot be made quickly, however, the bonds reside on dealer balance sheets. Because most of that activity occurs among bank-affiliated dealers, this inventory is constrained by the same size and complexity regulations as other activities. At a certain point, these increasing capital charges make it more expensive to intermediate subsequent transfers, which is often priced into overall transaction costs. This materialized in rather dramatic fashion in March. Though yields were declining, and therefore Treasury prices increasing, that arguably had more to do with a shift in monetary policy expectations (zero or even negative short-term interest rates for an extended period, quantitative easing and even yield curve control) than a fundamental shift in the supply/demand balance among longer-term investors. In fact, if anything foreign central banks, a key component of demand for Treasury bonds, were significant sellers throughout the decline in yields (as discussed in a recent post by Brad Setser in this blog). Basis trade unwinds added to already heavy inventories, reducing capacity and exponentially increasing the costs of intermediation. The impact was greatest in longer maturity securities: the bid/ask spread (a measure of transaction costs) that dealers charged each other to trade 30-year Treasuries, for example, was 20x larger than typical levels for a few days in March. The shock percolated across the Treasury yield curve such that the relationship between otherwise very similar securities became very volatile and uncertain (CHART 5). As many observed at the time, Treasuries were suddenly trading more like emerging market debt than obligations backed by the full faith and credit of the U.S. government (see a related discussion here). Large risk transfers have, of course, occurred many times in the past. While they can have a significant impact on prices, they do not typically threaten financial stability. But the scale of the breakdown in market functioning in mid-March was unprecedented, and threatened a new kind of financial crisis—one driven not by the quality of collateral used for short-term lending, like in 2008, but one in which the quantity sloshing around on bank balance sheets risked becoming destabilizing. Though at first glance the events of March bear little resemblance to the Lehman bankruptcy, the risk they posed were very similar: a disorderly delevering of the banking system, including fire-sales of otherwise high quality assets, in the midst of a historic shock to the real economy. How could a disruption in the Treasury market expand to envelope the system as a whole? And how did we avoid the most destructive outcomes? We explore that in our third and final installment.

This is a guest blog by Josh Younger, an interest rate strategist at J.P. Morgan. Joshua Younger is employed by the Research Department of J.P. Morgan Chase & Co. All views expressed in this forum are his own and may not align with those of the firm, but they are consistent with all research publications published under the firm brand for which he is listed as an author. This is part one of a three part series. Brad Setser notes that he believes this work is of great interest to the general public, given the scale of the market disruption in March. Among other superlatives that can be assigned to the COVID-19 pandemic, the re-pricing of global financial assets to reflect its economic implications was arguably the most rapid and unexpected of the modern era. For fixed income markets in particular, these moves were multiples of what the market considered plausible in the months prior. The decline in 10-year Treasury yields over the month ending in mid-March, for example, was nearly six times that implied by the cost of buying protection against those moves in the options market. By this measure—volatility-adjusted price change—that was the largest re-pricing of any monthly period in at least 30 years (CHART 1). This uniquely fast pace was consistent with the combination of a uniquely fast-moving event—even financial crises cannot approach the exponential growth exhibited by disease epidemics—and much more severe economic consequences—a synchronized global economic shutdown. Financial asset returns are famously fat-tailed, but a surprise of that magnitude should still be exceedingly rare. Even a conservative interpretation of the statistics suggests they should only occur once every thousand years or so. The ferocity of these moves put considerable strain on the basic functioning of markets that intermediate large transactions, even risk-free assets like Treasuries (see also Liberty Street Economics blog posts here and here). As a general matter, very large intraday price swings complicate the process of connecting buyers and sellers—market making. This reflects the fact that in many markets, including Treasuries, there is typically a time lag between the acquisition and placement of a security. If prices decline over that period, short though it may be, market makers could be forced to sell for less than what they paid, resulting in a loss. Traders guard against this risk to some degree by offering bonds for sale (the offer) at a higher price than they can buy them in the market (the bid). In principle they can widen this bid/ask spread to accommodate larger expected short-term price swings. But when volatility is rising, it can be difficult to keep up, and even a few minutes can quickly lead to significant losses. When market making risks becoming a money-losing enterprise, the solution is simple: reduce the size and/or pace of transactions or, in the extreme, simply stop trading all together. Though this was just as true of the street markets of medieval Paris as it is today, in modern electronic trading it is exacerbated by increased reliance on algorithms. Often referred to collectively as high frequency traders (HFTs), these computerized systems engage in an enormous number of transactions a day but only hold those positions for (ideally) a fraction of a second. That means their ideal environment is one of relatively stable prices and heavy volumes, so they can effectively monetize the bid/ask spread many times over. These strategies dominate activity across a number of markets, including Treasuries where the top four counterparties are far from household names and make up more than 60 percent of these transactions. HFT-style trading is also not limited to these dedicated outfits (i.e., principal trading firms, or PTFs)—many large bank-affiliated dealers now employ similar strategies for at least part of their market making business. HFT models have been quite successful in the relatively calm waters of the past few years, and they have grown to make up the vast majority of liquidity provided in the Treasury market. That means that ability to buy and sell large volumes at low cost has become increasingly dependent on their involvement. That all came crashing down in March as not only did prices oscillate violently over the course of the trading day, but the level of activity dried up as well (CHART 2). With fewer opportunities to profit from connecting buyers and sellers, and a much greater risk of losing money in the meantime, HFT-style market makers pulled back abruptly and in some cases likely shut down entirely. Thus the liquidity they provided dropped to a tiny fraction of its previous peak over the first couple weeks of March (CHART 3). When liquidity dries up, activity tends to migrate to the deepest, most actively traded, most transparent, and fungible product. For interest rates, that typically means Treasury futures, which are a contractual agreement to buy or sell a Treasury security on future date. These instruments have many advantages during periods of stress, not least among them the fact that they are a derivative rather than a ‘cash’ instrument, and that means they effectively offer leverage (aside from the required margin of course). If you need to quickly hedge significant interest rate risk without locking up or borrowing a lot of cash, this is an immensely valuable feature. When the going gets tough enough, this dynamic can have an impact on the relative pricing of different fixed income products with very similar underlying risk profiles, which we often refer to as liquidity tiering. Futures in particular tend to lead in disorderly market moves—dropping in price more than similar securities when interest rates are rising, and vice versa when they are falling. This is typically quantified by tracking the difference, or basis, between the futures contract price and the bond that is optimal (i.e., cheapest) to deliver into that contract (the cheapest-to-deliver, or CTD). Market convention is to quote the so-called cash/futures basis as the price of the CTD (with some adjustments, which we will not belabor here) minus that of the futures. Therefore, a drop in the value of this measure represents the outperformance of the futures contract. We are not talking about massive numbers here: among those who traffic in such things, even a 0.5 percent change in the pricing of futures relative to their CTD is considered a very large move indeed! But, as we will see, under the right circumstances even such a small discrepancy can have massive consequences. That leaves us with a sequence of events that should look very familiar to any interest rate trader: a spike in volatility led to a collapse in market depth and then a re-pricing of the cash/futures basis (CHART 4)*. Though markets had weathered episodes of severe illiquidity several times since 2008, financial stability was never directly threatened. This time was different, and anything but familiar. A confluence of events triggered by small shifts in relative pricing of different fixed income instruments ultimately threatened a financial crisis and disorderly deleveraging of the banking system in the middle of a historic shock to the real economy. The key lay in long dormant, highly levered positions held by professional investors but previously dismissed as having little impact on the market (if they were aware of it at all).     * Price impact is a complementary measure of liquidity to market depth, and quantifies the expected change in price for a imbalance of buyers versus sellers. More details on various measures of liquidity are available here.