Stocks, Interest Rates and Reverse RPs

December 8, 2023 | Premium Service | It is more than a little surprising to see how few Fed watchers appreciate that the Street’s rotation out of Reverse Repurchase Agreements (RRPs) and into T-bills essentially provided the catalyst for the November rally – and the cash to fund the ¾ of a point decline in yields in the Treasury market. As we were sitting in the trading room this AM, the jobs number came out and the 10-year Treasury moved from 4.17% to 4.25% in less than a minute.

In this issue of The Institutional Risk Analyst, we take stock of the world of fixed income and credit as the year ends. As in December of 2018, the Street has essentially closed its books for the year.  Large banks led by JPMorgan (JPM) have in so many words told the Street “no thanks” to new exposures, meaning that we may see more trouble in Repo land before the New Year.  Look at the upward spikes in the Fed funds rate over the past two weeks.

First let’s set the stage with a little data. The two major “adds” to the US markets in the past month have come from the runoff of RRPs at the Fed and expenditures by the Treasury from the TGA.  As we noted in our last post, when the Treasury spends cash, it results in increased reserves/deposits at banks.  Indeed, the inflows have largely offset the Fed’s QT policy to reduce reserves. The chart below from FRED shows RRPs (red) falling fast as the Treasury spends cash from the TGA ((blue).

Over the past year, as the Treasury has issued a large amount of T-bills to raise cash, the outflow from RRPs and also normal payment flows from the TGA into banks has more than floated the Treasury’s cash needs. The balance was available to flow into stocks and longer-dated Treasury debt, and it did! The result was a pop in stocks and also a rally in the long-end of the Treasury curve.

Our view is that once liquidity tightens in the markets in December and the next Treasury refunding approaches, the markets are likely to retreat in both stocks and fixed income. The Treasury plans to auction $816 billion in debt in the first quarter of 2024. This is in addition to $776 billion in debt that will be auctioned off in the final quarter of 2023. 

Many of the names that have rallied in the past month such as Customers Bancorp (CUBI). CapitalOne Financial (COF) and Ally Financial (ALLY) all rallied based upon an assumption of no recession in 2024. Even Citigroup (C) managed to rally 15% based upon announced layoffs to improve operating results. Note that despite the rally, Citi is still trading below 0.5x book.

Source: Bloomberg (12/7/2023)

Many of the names in our surveillance group continue to trade at significant discounts to book value, including our one common holding in New York Community Bank (NYCB).  The rally in November is likely to be very helpful to NYCB’s Flagstar unit because of increased lending volumes for the bank’s warehouse and loan servicing businesses. 

We note in this regard that PennyMac Financial (PFSI) just completed a $750 million six-year unsecured debt offering that was upsized from $650 million. The notes pay 7.875% and are rated Baa2 by Moody’s.

The moral of the story is that November was a good time to be an issuer of debt, especially if you understood the context of what is going on at the Fed in terms of cash flows into the financial markets. We believe that many of the consumer-facing names that rallied in November may now be set up for an equal or larger sell-off in the next month or so.  Notice in the chart below that T-bills (blue) are trading significantly above the yield on RRPs (red).

As markets come to appreciate that the FOMC may not be cutting short-term interest rates for some or possibly all of 2024, we think that the dynamics of the Treasury refunding in January and the near-complete runoff of RRP’s back into T-bills is likely to weigh on the markets. Simply stated, with T-bills trading significantly above the yield on RRPs, there is no reason for money market funds and other counterparties to leave cash at the Fed.

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