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Hedge funds under scrutiny over role in March bond market ructions

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Global policymakers are examining the role hedge funds played in the mayhem that enveloped the $20tn US Treasury market in March, warning that the Federal Reserve’s intervention could fuel more aggressive trading.

A report from the Financial Stability Board prepared ahead of this weekend’s G20 leaders summit underscores how central banks and regulators remain deeply uneasy over the turmoil this spring in one of the world’s most important financial markets.

The FSB, a rulemaking body composed of leading central bank and finance ministry officials, explored the role that “non-bank financial institutions” played in the crisis, and highlighted several areas that needed further study — and possible policy action.

One of the main aspects highlighted was the US Treasury market turbulence in March, which some investors and analysts say threatened to spiral into a financial crisis until the Fed intervened aggressively. 

US government debt is a bedrock of the financial system, thanks to its safety, ease of trading and the dollar’s reserve currency status. But in March, Treasuries were hit with a wave of selling that the banks that lubricate trading were unable to cushion, causing a series of dislocations that could have snowballed without the Fed’s actions, according to the FSB. 

Although foreign investors — primarily central banks — were among the biggest sellers, ditching almost $300bn of Treasury bonds and bills in March, the market’s “dysfunction” was “exacerbated” by the unwinding of a popular hedge fund trade that takes advantage of the difference between the prices of Treasury bonds and futures, which led to another $90bn of US government debt being dumped, according to the FSB. 

“Large-scale unwinding of these trades . . . was likely one of the contributors to a short period of extreme illiquidity in government bond markets,” the FSB said in the report published on Tuesday morning.

Line chart of the prices between US government bonds and the corresponding futures contract, showing how the unwinding of leveraged Treasury trade added to the market turmoil

The price differences between Treasury bonds and matching futures — derivatives that let traders speculate on or hedge exposure to US government debt — is usually tiny. However, hedge funds borrow large amounts to turn these modest discrepancies into relatively stable and profitable trades.

This “basis trade” came undone in March, when swaths of the bond market seized up and many global investors became desperate to raise cash in a hurry, forcing them to ditch Treasuries.

The fire sale caused the normally tiny differences between Treasury bonds and futures to balloon dramatically. That left hedge funds nursing losses, spurred banks to limit how much leverage they could take, and compelled many to ratchet back their Treasury basis trades.

The Managed Fund Association, a lobbying body for the hedge fund industry, argued on Tuesday that its members were not the primary driver of the turbulence, given that their sales were dwarfed by those of foreign investors.

“MFA looks forward to supporting policymakers with data and analysis as they continue to review the March turmoil and look for ways to strengthen financial market resilience,” Michael Pedroni, head of international affairs at the MFA, said in the statement.

Chart showing spreads between bid and ask prices for 10-year Treasuries

However, some analysts say that without Fed intervention, the basis trade unwinding would likely have escalated significantly, with some arguing it could even have imperilled the US government’s ability to fund itself at a pivotal time.

Commodity Futures Trading Commission data indicate that hedge funds held $750bn of gross positions in US Treasury futures at the start of the year, which analysts say is a good proxy for the size of the basis trade. Moreover, a chunk of the $300bn of foreign investor selling came from institutions based in the Cayman Islands, a favoured hedge fund domicile.

To quell the turmoil, the Fed injected trillions of dollars into the repo market, one the primary hubs for short-term lending, and committed to buying an unlimited quantity of Treasury securities, among other measures.

The FSB’s report lauded the “speedy, sizeable and sweeping” intervention. However, it noted that the financial system remained vulnerable to a repeat, as the “underlying structures and mechanisms that gave rise to the turmoil are still in place”, and highlighted possible downsides to the central bank’s response. 

“Aggressive policy actions may have changed private sector expectations of central bank actions in the future,” the report said. “This could lead to moral hazard issues in the future, to the extent that markets do not fully internalise their own liquidity risk in anticipation of future central bank interventions in times of stress.”

The FSB argued that the March turbulence underscored the importance of also strengthening the resilience of the non-bank parts of the financial system, after the primary focus after 2008 had been on buttressing the traditional banking industry. 

In addition to probing the role of “leveraged investors”, the FSB said it would focus on areas including money market funds; whether regulations constrained banks from ensuring orderly markets; margin call practices; and liquidity risks in traditional investment funds.

“The challenges posed by the ‘Covid event’ have by no means dissipated yet and we are just starting to draw the necessary lessons,” Randal Quarles, the Fed’s vice-chair in charge of financial supervision and chair of the FSB, said in a letter accompanying the report.



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Bond spreads collapse as investors rush into corporate debt

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The premium above super-safe US Treasuries that investors are demanding to buy corporate debt has dropped to its lowest level in more than a decade.

The collapse in the difference between yields — or spread — is a sign that investors are growing increasingly confident that recent rises in inflation will not hinder the booming economic recovery.

The spreads between US Treasury and corporate bond yields have tightened markedly this year, as investors gained confidence and clamoured to own even marginally higher yielding assets in a low return world.

That spread compression, which indicates the level of risk investors see in lending to companies compared to the US government, had come under pressure from the spectre of higher inflation from mid-April to May.

However, an increasing number of investors are coming around to the Fed’s mantra that price rises will prove transitory as the economy reopens after the pandemic, pushing measures of expected inflation lower.

“The Fed has been controlling the transitory narrative which has provided confidence to corporate bond investors,” said Adrian Miller, chief market strategist at Concise Capital Management. “After all, corporate bond investors are more focused on the expected strong growth path.”

Line chart of Spread on US corporate bonds, by rating (percentage points) showing Investors are demanding less yield to lend to US companies

Confidence in the economic recovery was further bolstered on Wednesday as Fed officials signalled a shift toward the eventual repeal of crisis policy measures, embracing a more optimistic outlook of America’s rebound. The more hawkish tone from Fed chair Jay Powell — including comments that “price stability is half of our mandate” at the Fed — has helped to mollify concerns that inflation could run out of control, forcing a more abrupt response from the central bank.

The spread between US Treasury yields and investment grade corporate bond yields fell 0.02 percentage points to 0.87 per cent on Wednesday, according to ICE BofA Indices, its lowest level since 2007, and was unchanged on Thursday. For lower rated — and therefore riskier — high-yield bonds, the spread fell 0.05 percentage points to 3.12 per cent, below a post-crisis low last set in October 2018. It widened modestly to 3.15 per cent on Thursday.

The slide in spreads has been buoyed by the central bank’s accommodative policies through the pandemic crisis as well as the federal government’s multitrillion-dollar pandemic aid package. Financial conditions in the US are close to their easiest on record, according to a popular index run by Goldman Sachs, which has spurred a wave of corporate borrowing by riskier junk-rated businesses.

Some 373 junk-rated companies have borrowed through the nearly $11tn US corporate debt market so far this year, including companies hard hit by the pandemic like American Airlines and cruise operator Carnival. Collectively the risky cohort has raised $277bn, a record pace and up 60 per cent from year ago levels, according to data provider Refinitiv.

Column chart of Annual proceeds from high-yield US corporate bond sales ($bn) showing Risky junk-rated US companies are issung debt at a record pace

However the fall in spreads and investors’ perception of risk has not been enough to outweigh an overall rise in yields, which have been jolted higher by the prospect of rising interest rates as investors adjusted to a quicker pace of policy tightening from the Fed.

Higher rated debt, which is safer but offers less of a spread to cushion investors against a jump in Treasury yields, tends to suffer more in high growth, rising interest rate environments. High-yield bonds on the other hand tend to benefit, with the booming economy making it less likely that companies will go bust.

“For the time being people are not at all fearing the price action of a move higher in yields,” said Andrzej Skiba, head of US credit at BlueBay Asset Management. “Companies are doing really well and we are seeing a meaningful recovery in earnings.”

Investment-grade bond yields have moved 0.3 percentage points higher to 2.08 per cent since the start of the year, compared with a decline of 0.27 percentage points to 3.97 per cent for high-yield bonds.

Bank of America analysts expect the two markets to keep coming closer together, projecting that investment-grade spreads will widen to 1.25 per cent and high-yield bond spreads will continue to decline to 3.00 per cent in the coming months.

However, while optimism about the US recovery abounds the continued zeal for lower-quality corporate debt has caused consternation in some quarters. Investors worry that precarious companies are being offered credit at interest rates that don’t account for the high levels of risk involved.

“It’s very important for us that the yield we receive on a high-yield bond offers an appropriate level of compensation for the credit risks of investing. When yields are as low as this, that naturally becomes harder to say,” said Rhys Davies, a high yield portfolio manager at Invesco. “It’s quite simple — the lower the yield on the high yield market, the more carefully investors need to navigate the market.”



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Global stocks slip and bonds weaken after Fed signals tighter policy

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Global stock markets dipped, European government bonds dropped and the dollar strengthened sharply after US central bank officials brought forward the anticipated timing of the Federal Reserve’s first post-pandemic interest rate rise.

The FTSE All-World index of developed and emerging market stocks, which hit a closing record on Monday, headed for its third session of losses on Thursday, falling 0.6 per cent.

The Federal Reserve said on Wednesday that most of its officials expected a rate rise in 2023, against earlier predictions of 2024, as the US economy recovered strongly from the pandemic and consumer price inflation hit an annual rate of 5 per cent in May.

Fed chair Jay Powell also said the world’s most influential central bank was “talking about talking about” reducing the Fed’s $120bn-a-month asset-buying programme that has boosted financial markets since March last year.

The announcement rattled the US Treasury market on Wednesday, as the prospect of higher interest rates on cash lowered expected returns from fixed interest securities such as bonds, with traders in Europe following those moves in the next session.

“It was a hawkish surprise,” said Keith Balmer, multi-asset portfolio manager at BMO Global Asset Management. “Markets now see the Fed as stepping in to control inflation earlier than expected,” he added, following previous comments from Powell that suggested price rises above the central bank’s long-term 2 per cent target would be temporary.

Line chart of FTSE All-World index  showing Global stocks dip from record high

The dollar index, which measures the greenback against trading partners’ currencies, jumped 0.7 per cent after gaining a similar amount on Wednesday as traders anticipated higher returns from holding the world’s reserve currency. The euro lost 0.5 per cent against the dollar to $1.193.

The yield on the benchmark 10-year Treasury note, which jumped 0.09 per cent on Wednesday evening to 1.58 per cent following the decision from the US central bank, moderated slightly in European trading hours to 1.558 per cent.

European bond yields, which move inversely to prices, raced higher as traders bet on other central banks following the Fed to rein in their crisis-era stimulus spending. The UK’s 10-year gilt yield rose 0.09 percentage points to 0.828 per cent. Germany’s equivalent Bund yield added 0.04 percentage points to minus 0.164 per cent.

Stock markets were less affected by the rate increase forecast as investors focused on the strength of the post-pandemic economic recovery and bought up shares in businesses expected to benefit from higher borrowing costs.

The Stoxx Europe 600 index, which rallied to an all-time high on Wednesday, fell 0.3 per cent on Thursday. Shares in European banks, which benefit from higher interest rates that enable lenders to make wider profit margins, gained 1.2 per cent.

The next US rate rise “will be happening at a time when the [global] economy is able to stand on its feet”, said Zehrid Osmani, manager of Martin Currie’s global portfolio trust.

Futures markets signalled the S&P 500 index would slip just 0.2 per cent at the New York opening bell after declining 0.5 per cent on Wednesday, while the top 100 stocks on the technology-focused Nasdaq Composite would lose 0.3 per cent.

Elsewhere in markets, the Norwegian krona rose 0.1 per cent against the euro to €0.984 despite the Norges Bank saying it was likely to raise interest rates in September. Some traders had expected an increase on Thursday.

Brent crude, the international oil benchmark, rose 0.1 per cent to $74.48 a barrel.



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Hawkish Federal Reserve forecasts jolt Treasury market

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US equities slid and Treasury yields surged after policymakers at the Federal Reserve signalled that they expected to lift interest rates in 2023, a year earlier than previously thought.

The benchmark S&P 500 fell 0.6 per cent, led by a decline in the shares of technology companies including Oracle, Microsoft and Facebook. The Nasdaq Composite was also down 0.6 per cent.

The equity market decline accompanied a sell-off in the $21tn Treasury market, where the yield on the benchmark 10-year note rose 0.06 per cent to 1.56 per cent.

Among shorter-dated government bonds most sensitive to interest rate policy, there were even larger moves. The yield on the five-year note climbed 0.09 percentage points to 0.88 per cent, while the yield on the two-year note briefly hit its highest level in a year at 0.19 per cent.

“Just as the market was getting comfortable with a patient Fed and inflation considerably above target, the dot plot has shifted,” said Seema Shah, the chief strategist of Principal Global Investors, referring to the graph showing Fed officials’ interest rate predictions.

“Now it will be up to [Fed chair Jay] Powell and other Fed speakers to once again reassure markets that tightening in 2023 doesn’t need to be disruptive.”

The equity market rally over the past year has been in part predicated on rock-bottom interest rates, which the Fed has anchored near zero since the crisis began in March last year.

While policymakers at the US central bank showed that they could raise rates sooner than previously thought, they did not yet signal changes to the Fed’s $120bn-a-month asset buying programme, which investors are starting to expect will be tapered soon.

But markets have worried that signs of higher inflation, which Fed policymakers acknowledged in their economic projections published on Wednesday, could force the central bank’s hand.

“Given that the only takeaways from the Fed update involved higher rates, it follows intuitively that Treasuries are trading lower,” said Ian Lyngen, the head US interest rate strategist at BMO Capital Markets.

Ian Shepherdson, the chief economist at Pantheon Macroeconomics, added that the forecast for higher rates in 2023 meant that members of the Fed’s policy-setting committee “now are ready to talk tapering, so chair Powell is not going to be able to repeat his March/April stonewalling . . . We expect him just to acknowledge that the discussion is under way, but that a firm decision is a way off.”

The US dollar index climbed 0.4 per cent along with the uptick in Treasury yields. The pound fell 0.4 per cent against the dollar, while the euro slipped 0.7 per cent to $1.20.

European stocks finished at new records before the release of the Fed decision. The Stoxx Europe closed up 0.2 per cent for another all-time peak, the region-wide benchmark’s ninth session of back-to-back rises.

Frankfurt’s Xetra Dax rose 0.1 per cent, while both the CAC 40 in Paris and London’s FTSE 100 climbed 0.2 per cent.

Additional reporting by Siddharth Venkataramakrishnan in London

Unhedged — Markets, finance and strong opinion

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