Analyzing Funding Market Stress and Investor Behavior

Our analysts Vishy Tirupattur and Martin Tobias explain how the announcement of new tariffs and the subsequent pause in their implementation affected the bond market.

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Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's, Chief Fixed Income Strategist.

Martin Tobias: And I'm Martin Tobias, from the U.S. Interest Rate Strategy Team.

Vishy Tirupattur: Yesterday the U.S. stock market shot up quite dramatically after President Trump paused most tariffs for 90 days. But before that, there were some stresses in the funding markets. So today we will dig into what those stresses were, and what transpired, and what investors can expect going forward.

It's Thursday, April 10th at 11:30am in New York.

President Trump's Liberation Day tariff announcements led to a steep sell off in the global stock markets. Marty, before we dig into that, can you give us some Funding Markets 101? We hear a lot about terms like SOFR, effective fed funds rate, the spread between the two. What are these things and why should we care about this?

Martin Tobias: For starters, SOFR is the secured overnight financing rate, and the effective fed funds rate – EFFR – are both at the heart of funding markets.

Let's start with what our listeners are most likely familiar with – the effective fed funds rate. It's the main policy rate of the Federal Reserve. It's calculated as a volume weighted median of overnight unsecured loans in the Fed funds market. But volume in the Fed funds market has only averaged [$]95 billion per day over the past year.

SOFR is the most important reference rate for market participants. It's a broad measure of the cost to borrow cash overnight, collateralized by Treasury securities. It's calculated as a volume weighted median that covers three segments of the repo market. Now SOFR volumes have averaged 2.2 trillion per day over the past year.

Vishy Tirupattur: So, what you're telling me, Marty, is that the, the difference between these two rates really reflects how much liquidity stress is there, or the expectations of the uncertainty of funding uncertainty that exists in the market. Is that fair?

Martin Tobias: That's correct. And to do this, investors look at futures contracts on fed funds and SOFR.

Now fed funds futures reflect market expectations for the Fed's policy rate, SOFR futures reflect market expectations for the Fed policy rate, and market expectations for funding conditions. So, the difference or basis between the two contracts, isolates market expectations for funding conditions.

Vishy Tirupattur: So, this basis that you just described. What is the normal sense of this? Where [or] how many basis points is the typical basis? Is it positive? Is it negative?

Martin Tobias: In a normal environment over the past three years when reserves were in Abundancy, the three-month SOFR Fed funds Futures basis was positive 2 basis points. This reflected SOFR to set 2 basis points below fed funds on average over the next three months.

Vishy Tirupattur: So, what happened earlier this week is – SOFR was setting above effective hedge advance rate, implying…

Martin Tobias: Implying tighter funding conditions.

Vishy Tirupattur: So, Marty, what actually changed yesterday? How bad did it get and why did it get so bad?

Martin Tobias: So, three months SOR Fed funds tightened all the way to -4 basis points. And we think this was a reflection of investors’ increased demand for cash; whether it was lending more securities outright in repo to raise cash, or selling securities outright, or even not lending excess cash in repo. This caused dealer balance sheets [to] become more congested and contributed to higher SOFR rates.

Vishy Tirupattur: So, let's give some context to our listeners. So, this is clearly not the first time we've experienced stress in the funding markets. So, in previous episodes – how far did it get and gimme some context.

Martin Tobias: Funding conditions did indeed tighten this week, but the environment was far from true funding stress like in 2019 and certain periods in 2020. Now, in 2019 when funding markets seized, and the Fed had to intervene and inject liquidity, three months SOFR fed funds basis averaged -9 basis points. And that compares to -4 basis points during the peak macro uncertainty this week.

Vishy Tirupattur: So, Marty, what is your assessment of the state of the funding markets right now?

Martin Tobias: Right. Funding conditions have tightened, but I think the environment is far from true funding stress. Thus far, the repricing has occurred because of a higher floor for funding rates and not a scarcity of reserves in the banking system.

Vishy Tirupattur: So, to summarize, so the funding stress has been quite a bit earlier this week. Not as bad as the worst conditions we saw say in 2019 or during the peak COVID periods in 2020. but still pretty bad. And relative to how bad it got, today we are slightly better than what we were two days ago. Is that a fair description?

Martin Tobias: Yes. That's good. Now, Vishy, what is your view on why the longer end of the bond market sold off.

Vishy Tirupattur: So longer end bond markets, as you know, Marty, while safe from a credit risk perspective, do have interest rate sensitivity. So, the longer the bonds, the greater the interest rate sensitivity. So, in periods of uncertainty, such as the ones we are in now, investors prefer to be in ultra short-term funds or cash – to minimize that interest rate sensitivity of their portfolios. So, what we saw happening in some sense, we can call it dash for cash.

I think we both agree that this demand for safety will persist, and we will continue to see inflows into money market funds, which you covered in your research. So, your insights Marty will be very helpful to clients as we navigate these choppy waters going forward.

Thanks a lot, Marty, for joining this webcast today.

Martin Tobias: Great speaking with you, Vishy,

Vishy Tirupattur: And thanks for listening. If you enjoy the show, please leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.

Disclaimer

Vishy Tirupattur: Yesterday all my troubles were so far away. I believe in yesterday.