MARKET ANALYSIS: Short rates test the ZLB/negative territory amid collateral shortage, stoking Fed action calls

Analysis details (13:34)

While duration in fixed income - particularly in the US - has been selling off as of late, an interesting dichotomy along the curve has emerged as short-term rates have been and continue to richen amid the shrinking supply of collateral and the abundance of cash to chase it. With key benchmarks such as SOFR, T-Bills, and Fed Funds approaching the Zero Lower Bound, the media and broader (non-rates) market community have started to take note, and with it, speculation on what the Fed could do to protect its FFR target range (0-25bps), where the central bank's mandate is to ensure the Effective Fed Funds Rate (steady at 7bps as of Monday's print) stays in that range. Whereas other secured/unsecured rates, and what level they trade at, is a matter of preference for the Fed, and not its mandate. But, with SOFR at 1bps and 1m bills at 4bps, the Fed will be cognizant of the risk of EFFR falling too. If more downward pressure emerges, analysts largely expect the Fed to announce a hike in the IOER and RRP facility to counter the move, measures it has used in the past as buffers against deviations in the EFFR.   

Amplifying the trundle lower at the front-end has been the US Treasury and its efforts to paydown outstanding bills, mechanically reducing the supply of collateral whilst raising the reserves (cash) in the money markets to chase it as it draws down the TGA at the Fed. As things stand, the Treasury will continue drawing down the General Account (currently USD 1.53trln) at the Fed in efforts to reduce its holdings to the USD 133bln level required by July-end due to legal requirements of the debt limit. A crucial caveat is that if, as looks most likely, Congress is to pass through a new stimulus bill (exp. USD 1.5-1.7trln), this could flip the Treasury bill supply into net positive and immediately reverse the collateral shortage issues that are plaguing the money markets. However, until then, the trend appears lower. Indeed, with bills approaching the ZLB, flirting with negative, this has had knock-on effects for other money market instruments, such as repos, which have tracked the move lower; there are currently certain "specials" in repo markets that are trading in negative (also known as bilateral-cleared repo). 

The Secured Overnight Finance Rate (SOFR) is now in focus after recently hitting the 1bps mark, and is getting broader attention amid its proximity to negative. The rate, which is a volume-weighted median of various repo transactions, will struggle to actually trade beneath 0% according to Barclays for several reasons. For one, the Fed removes the bottom 25% of the volume distribution of cleared bilateral repo trades ("specials'') before calculating a median rate on the full SOFR volume in order to separate "specials activity" (which is where the negative repos are present). The bank notes that the inter-quarterly distribution of SOFR rates has tended to compress at low rates, where SOFR seems to converge to zero, rather than go through it. Tri-party rates (non-specials) may not also trade below zero, as money funds, GSEs, and others can leave their cash on the Fed’s balance sheet, although Barcs says the tri-party share of SOFR has fallen. The bank concludes for SOFR to print negative, a lot higher share of bilateral-cleared repo (specials) would have to trade negative, for which currently isn't the case, so for now, the ZLB should be respected for SOFR.

02 Mar 2021 - 13:33- Fixed IncomeResearch Sheet- Source: Newsquawk