A core component of economic growth is liquidity, often measured through the cost and availability of credit. The central starting place for liquidity conditions is the short-term collateralized lending market. This is often viewed as the safest market since it is short duration and has assets posted to offset any losses or delays in payment. This source of funds and liquidity is where money dealers and global intermediates derive their liquidity to provide capital to the rest of the global market. An increase in asset volatility can disrupt these markets, as heightened volatility can make it more difficult to price collateral. This can lead to a narrowing set of assets that are acceptable for collateral. This can lead to selling of other assets as they are no longer useful in gaining access to liquidity. Increased downside volatility can also have a negative impact as borrowers will be required to post more collateral at a time when they may not have available capital, which causes their collateral to be liquidated, adding to the downside price momentum and volatility.
Over the last few weeks, major asset classes have experienced increased volatility. The charts below are measures of volatility in foreign exchange, Treasuries, equities, gold, and oil.
There are data points and market indicators we can observe and follow to show strains in the collateralized lending market and the impact this has in other areas.
If high-quality assets that are eligible for short-term collateralized lending are becoming scarce, one of the first markers will be an increase in repurchase agreement failures. This data point measures situations where either the side posting collateral or the side holding the collateral failed to hold up their end of the agreement (one side doesn’t deliver the funds or doesn’t post the collateral). This is an indication that collateral is hard to come by and market participants do not want to give up the limited amount that is available.
Another sign that market participants are having trouble accessing collateral is securities dealers borrowing from the Federal Reserve’s Treasury holdings. This often occurs when dealers need to source Treasuries to post as collateral to maintain liquidity functions for their end clients at a time when other market participants are not willing to part with their Treasury holdings.
These tight conditions in the collateral market can manifest in a premium price for short-term government securities. In the current environment, several developed market short-term government bonds yield less than short-term deposit rates and central bank target rates. This could be a sign that these short-term securities are in such high demand that they trade at a premium to what investors could make in overnight deposit accounts. This often occurs during times when the holders of those securities are concerned about being able to replace them if they need to borrow in the secured market.
The strain that tight collateral markets have on other areas can be seen in credit markets like credit default swaps for countries and financial entities (many of which are making new cycle highs).
Much of the collateralized lending market is used to facilitate access to US dollars, and when liquidity conditions tighten these can be observed in cross currency basis swap spreads (they get more negative as a reflection of the increased premium being paid to access U.S. dollars). These conditions can also lead to lower exchange rates compared to the U.S. dollar. At the current time, many developed market cross currency basis swaps spreads and exchange rates are making cycle or multi-decade lows.
In periods of elevated volatility, uncertainty around the pricing of assets, and specifically collateral, makes it difficult for banks to continue lending. Therefore, credit markets tend to slowdown in periods of high interest rate volatility. In severe cases, banks can halt all overnight and securitized lending. Without credit growth, economic activity slows as businesses find it more costly to finance their operations.
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Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC