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Dealing fix for Treasury securities market is needed now

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The Trump Show made the point that the US never really settled the war with the Confederacy. During the Biden administration, the conflict between large dealer banks and the populist left will be more bitter than ever.

To the dealer banks, the Dodd Frank Act and the Basel Accords on bank regulation were heavy handed over-reach. To US financial reform activists, the banks and their traders are still getting away with too much money and freedom of action.

Unfortunately, the squabbles between the dealers banks and activists could interfere with financing the ambitious Biden administration and Congressional spending plans, which come on top of Trump’s $7.8tn borrowing spree.

Central bankers outside the US have their doubts about whether the US dealer banks have sufficient balance sheet capacity to maintain an orderly market for Treasury securities.

As one of them says: “There was already a lot to be done in the plumbing of the Treasury market, and those requirements get more pronounced with the bigger budgets. If we cannot get reliable Treasury prices, other markets become even more unstable.”

Disruptions in the Treasury market and repo market (for lending against securities) such as those in March of last year, and September 2019, now seem to occur every few months, rather than every couple of decades. To reduce the systemic risk of market dysfunction, the dealer banks argue they need fewer Dodd-Frank and Basel constraints and charges on the size of their trading books. The activists take the opposite view, saying there should be more rules, enforced more strictly.

The moderate reformers fiddle with their bow ties and murmur that Treasuries and repo need a better and more heavily reinforced plumbing system for the Treasury and repo market flows. Specifically, there is increasing support in the academic and bureaucratic wings of the financial system for putting all Treasury trading and repo transactions through a central clearinghouse, or CCP.

Many people on dealer bank trading desks are unenthusiastic about a giant Treasury-repo-CCP construction. What they really want is to have the constraints and costs on balance sheet growth lifted, at least for Treasury securities and repo.

As one of them says: “When Trump and (Fed governor Randy) Quarles came in we thought we would see some real easing of regulation of the dealers. Instead, the Treasury and Fed went along with all the Basel influenced limits on our ability to warehouse Treasuries and do repo.”

Sadly, from the point of view of the dealer-desk people, Trump-promised deregulation did not happen. In March of last year, the Fed announced a temporary change in the big dealer bank’s SLRs (supplementary lending ratios) to exclude Treasury positions from the limiting rules for bank holding companies. As our dealer person says, though: “They did not carve out repo (positions from leverage limits). So the carve-outs they did were ineffective.”

And even the temporary carve out of Treasury positions from the regulators’ calculations of the banks’ leverage limits expires at the end of March. Financial reform activists have already said they will oppose an extension of the Fed’s temporary rule-loosening, although they will probably not be successful — this time. But stricter regulation of dealers’ behaviour and balance sheets is coming soon.

The US dealer banks appear to have enough room on their balance sheets to accommodate sedate, day-to-day trading in the Treasury market, for now. There is, however, greater risk of discontinuous or disorderly markets with even a moderate piece of bad news.

Would putting all Treasury trades through a CCP reduce the risk of market instability and outright dysfunction?

Darrell Duffie, a Stanford finance professor and Treasury clearing house advocate, says yes. “It would take these trades off the dealers’ balance sheets, and you would have an opportunity for exchanges to allow investors to trade directly with each other.

“It would at least initially be more expensive but it would prevent market failures. And there is no way the dealer balance sheets can grow as fast as Treasury issuance. We need bigger pipes.”

A Treasury CCP would take a couple of hundred billion in capital and years in set-up time. Congress will have to act — soon — on funding and enabling legislation.



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European stocks stabilise ahead of US inflation data

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European equities stabilised on Wednesday after a US central banker soothed concerns about inflation and an eventual tightening of monetary policy that had driven global stock markets lower in the previous session.

The Stoxx 600 index gained 0.4 per cent and the UK’s FTSE 100 rose 0.6 per cent. Asian bourses mostly dropped, with Japan’s Nikkei 225 and South Korea’s Kospi 200 each losing more than 1.5 per cent for the second consecutive session.

The yield on the 10-year US Treasury bond, which has dropped in price this year as traders anticipated higher inflation that erodes the returns from the fixed interest securities, added 0.01 percentage points to 1.613 per cent.

Global markets had ended Tuesday in the red as concerns mounted that US inflation data released later on Wednesday could pressure the Federal Reserve to start reducing its $120bn of monthly bond purchases that have boosted asset prices throughout the Covid-19 pandemic.

Analysts expect headline consumer prices in the US to have risen 3.6 per cent in April over the same month last year, which would be the biggest increase since 2011. Core CPI is expected to advance 2.3 per cent. Data on Tuesday also showed Chinese factory gate prices rose at their strongest level in three years last month.

Late on Tuesday, however, Fed governor Lael Brainard stepped in to urge a “patient” approach that looks through price rises as economies emerge from lockdown restrictions.

The world’s most powerful central bank has regularly repeated that it will wait for several months or more of persistent inflation before withdrawing its monetary support programmes, which have been followed by most other major global rate setters since last March. Investors are increasingly speculating about when the Fed will step on the brake pedal.

“Markets are intensely focused on inflation because if it really does accelerate into this time near year, that will force central banks into removing accommodation,” said David Stubbs, global head of market strategy at JPMorgan Private Bank.

Stubbs added that investors should look more closely at the month-by-month inflation figure instead of the comparison with April last year, which was “distorted” by pandemic effects such as the price of international oil benchmark Brent crude falling briefly below zero. Brent on Wednesday gained 0.5 per cent to $69.06 a barrel.

“If you get two or three back-to-back inflation reports that are very high and above expectations” that would show “we are later into the economic recovery cycle,” said Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management.

He added that the pandemic had sped up deflationary forces that would moderate cost pressures over time, such as the growth of online shopping that economists believe constrains retailers’ abilities to raise prices. Widespread working from home would also encourage more parents and carers into full-time work, he said, “increasing the labour supply” and keeping a lid on wage growth.

In currency markets on Wednesday, sterling was flat against the dollar, purchasing $1.141. The euro was also steady at $1.214. The dollar index, which measures the greenback against a group of trading partners’ currencies, dipped 0.1 per cent to stay around its lowest since late February.



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Potash/grains: prices out of sync with fundamentals

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The rising tide of commodity prices is lifting the ricketiest of boats. High prices for fertiliser mean that heavily indebted potash producer K+S was able to report an unusually strong first quarter on Tuesday. Some €60m has been added to the German group’s full year ebitda expectations to reach €600m. Its share price has gone back above pre-pandemic levels.

Demand for agricultural commodities has pushed prices for corn and soyabeans from decade lows to near decade highs in less than a year. Chinese grain consumption is at a record as the country rebuilds its pork herd. Meanwhile, the slowest Brazilian soyabean harvest in a decade, according to S&P Global, has led to supply disruptions. Fertiliser prices have risen sharply as a result.

But commodity traders have positioned themselves for the rally to continue for some time to come. Record speculative positions in agricultural commodities appear out of sync even with a bullish supply and demand outlook. US commodity traders have not held so much corn since at least 1994. There are $48bn worth of net speculative long positions in agricultural commodities, according to Saxo Bank.

Agricultural suppliers may continue to benefit in the short term but fundamentals for fertiliser producers suggest high product prices cannot last long. The debt overhang at K+S, almost eight times forward ebitda, has swelled in recent years after hefty capacity additions in 2017. Meanwhile, utilisation rates for potash producers are expected to fall towards 75 per cent over the next five years as new supply arrives, partly from Russia. 

Yet K+S’s debt swollen enterprise value is still nine times the most bullish analyst’s ebitda estimate, and 12 times consensus, this year. Both are a substantial premium to its North American rivals Mosaic and Nutrien, and OCI of the Netherlands, even after their own share prices have rallied.

Any further price rises in agricultural commodities will depend on the success of harvests being planted in the US and Europe. Beyond restocking there is little that supports sustained demand.

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Amazon sets records in $18.5bn bond issue

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Amazon set a record in the corporate bond market on Monday, getting closer to the level of interest paid by the US government than any US company has previously managed in a fundraising. 

The ecommerce group raised $18.5bn of debt across bonds of eight different maturities, ranging from two to 40 years, according to people familiar with the deal. On its $1bn two-year bond, it paid just 0.1 percentage points more than the yield on equivalent US Treasury debt, a record according to data from Refinitiv.

The additional yield above Treasuries paid by companies, or spread, is an indication of investors’ perception of the risk of lending to a company versus the supposedly risk-free rate on US government debt.

Amazon, one of the pandemic’s runaway winners, last week posted its second consecutive quarter of $100bn-plus revenue and said its net income tripled in the first quarter from the same period a year ago, to $8.1bn.

The company had $33.8bn in cash and cash equivalents on hand at the end of March, according to a recent filing, a high for the period.

“They don’t need the cash but money is cheap,” said Monica Erickson, head of the investment-grade corporate team at DoubleLine Capital in Los Angeles.

Spreads have fallen dramatically since the Federal Reserve stepped in to shore up the corporate bond market in the face of a severe sell-off caused by the pandemic, and now average levels below those from before coronavirus struck.

That means it is a very attractive time for companies to borrow cash from investors, even if they do not have an urgent need to.

Amazon also set a record for the lowest spread on a 20-year corporate bond, 0.7 percentage points, breaking through Alphabet’s borrowing cost record from last year, according to Refinitiv data. It also matched the 0.2 percentage point spread first paid by Apple for a three-year bond in 2013 and fell just shy of the 0.47 percentage points paid by Procter & Gamble for a 10-year bond last year.

Investor orders for Amazon’s fundraising fell just short of $50bn, according to the people, in a sign of the rampant demand from investors for US corporate debt, even as rising interest rates have eroded the value of higher-quality fixed-rate bonds.

Highly rated US corporate bonds still offer interest rates above much of the rest of the world.

Amazon’s two-year bond also carried a sustainability label that has become increasingly attractive to investors. The company said the money would be used to fund projects in five areas, including renewable energy, clean transport and sustainable housing. 

It listed a number of other potential uses for the rest of the debt including buying back stock, acquisitions and capital expenditure. 

In a recent investor call, Brian Olsavsky, chief financial officer, said the company would be “investing heavily” in the “middle mile” of delivery, which includes air cargo and road haulage, on top of expanding its “last mile” network of vans and home delivery drivers.



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