Increased regulation across the globe has driven banks to pragmatically review the use of their balance sheets. Higher hurdles for return on equity have led these institutions to reconsider their commitments to the repo market, the plumbing of our financial system. There are obvious consequences – including increased financing costs – but there are also hidden consequences. Recently, there has been speculation this recalibration of the repo market has been driving swap spreads to tighter levels. Swap spreads (the spread between a U.S. Treasury and a matched maturity interest rate swap) have been under a massive correction since July when 10-year spreads went from a local high of 12 bps to -7 bps currently. Investors are speculating as to why.
- Is it because foreign central banks sold U.S. Treasuries to fight against devaluations of their currencies?
- Is it due to increased debt issuance from corporates?
- Or, is it because dealer balance sheets have been shrinking, causing term financing (repo) costs, which are increasing, to have more of an impact on swap spread levels?
While central bank selling and corporate issuance are easier to distinguish in the market, the effect of shrinking balance sheets is harder to pin down. The repo markets are the pipes of the Treasury market’s plumbing, providing levered players with the access necessary to borrow and lend securities. It is true that costs of financing are increasing in repo markets, but the reasons aren’t as clear cut as they may seem. Balance sheets are definitely tighter as market participants migrate balance sheet availability to higher margin (more difficult to finance) assets. But part of the reason term repo levels are moving higher is the markets expectation of a Fed rate hike in December, a factor that is being overlooked as investors consider swap spreads.
Balance sheets are one of the main resources market participants use to articulate views on swap spreads. The scarcity of this resource has made it increasingly difficult for those investors to fight the tightening in swap spreads and will prove to do so in the foreseeable future. This issue will only be exacerbated around sensitive dates (quarter-ends, regulatory reporting dates, etc.) and we’ll likely see continued and pronounced volatility in swap spreads around these periods.
So while the increasing cost of financing likely isn’t the primary factor in driving swap spreads tighter, it will be a large factor in preventing a correction. It does however act as a real time barometer of the cost of capital for investors and banks, and should be closely followed by all. The bottom line is that continued balance sheet contraction should not necessarily be feared, but monitored to understand how the cost of capital is evolving.