How the Repo Market Could Crash Stocks in April

The Fed’s staying dovish and doesn’t plan on hiking the federal funds rate until after 2023.

So, stocks are soaring, right?

Well, not exactly. Yields shot higher again today and the tech sector sunk in response. Growth stocks abhor high rates, especially when they jump up unexpectedly.

And that’s exactly what happened this morning. The 10-year Treasury yield hit 1.75%, a 14-month high. The 30-year rate is up, too, to 2.5% – a level we haven’t seen since August 2019.

Tech stocks are diving deeply enough to pull down the general market. Only the Dow is up on the day among the three major indexes.

The “next leg up” may be in jeopardy as a result.

“Risk of rates rising too fast remains a key concern,” explained Craig Johnson, technical market strategist at Piper Sandler.

“Buying pressure has not been equal over the last several weeks as growth stocks lag behind due to headwinds from higher interest rates.”

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It’s somewhat of a surprise after Fed Chairman Jerome Powell announced yesterday that the Fed would continue to provide liquidity through monthly bond purchases. More importantly, Powell said that no changes (or tapering) to those bond purchases would occur.

“The [FOMC] expects to be extraordinarily accommodative for a very long time to come, even as the economic outlook brightens,” wrote AllianceBernstein economist Eric Winograd.

“The FOMC shares the market’s view that growth and inflation are likely to rebound as activity surges in 2021, but it does not view that surge in activity as durable.”

The cause for today’s Treasury slump may have actually happened “beneath the surface,” in the less-observed repo market that can often have a profound effect on yields.

Yesterday, the Fed decided to increase the reverse repo (RRP) counterparty limit – the limit at which a counterparty may make a single bid – from $30 billion to $80 billion. It’s a seemingly unimportant change, but one that may reverberate through Treasurys significantly.

For those who aren’t familiar with repo/reverse repo, each portion represents two parts of a transaction. A repo is an agreement between parties where the buyer temporarily purchases a group of securities for a specific period. Then, the buyer agrees to sell those same securities back to the original owner at a slightly higher price via a reverse repo. It’s a way for the Fed to “mop up” excess cash being held by banks, so it can control rates easier should it need to.

Currently, RRP counterparties invest cash at the Fed in exchange for Treasurys at a rate of 0.0%. The higher the RRP counterparty limit, the more cash invested at zero percent, thus driving rates down.

By raising the RRP counterparty limit, the Fed opened a channel to zero percent or even negative rates. At present, RRPs aren’t really happening. There was no RRP activity back on Monday, for example. The increased limit isn’t being used.

To Credit Suisse bond guru Zoltan Pozsar, that could pose a major problem as supplementary leverage ratio (SLR) relief is set to expire in a few weeks – something that would spark an epic wave of Treasury selling among banks, thus spiking yields.

Pozsar said:

“In our view, the fact that the Fed made this adjustment practically preemptively – the o/n RRP facility is not being used at the moment, so there are no capacity constraints yet, while repo and bill yields aren’t trading negative yet – suggests that the Fed is “foaming the runway” for the end of SLR exemption: ending the exemption of reserves and Treasuries from the calculation of the SLR may mean that U.S. banks will turn away deposits and reserves on the margin (not Treasuries) to leave more room for market-making activities, and these flows will swell further money funds’ inflows coming from [treasury general account] drawdowns.”

Pozsar’s remarks likely scattered bond buyers to the wind. Now, a major showdown approaches as SLR exemptions expire on March 31st.

If nothing else changes, tech should get absolutely hammered by a surge in yields. Powell said he’d make an announcement on SLR exemptions in the coming days.

Unless bond buyers (and holders) like what they hear, though, a major reckoning could follow.

Initiated by a small adjustment that was stealthily made in, of all things, the lowly repo market.

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