A SOFR spike! Who’s excited?!
I don’t know how much attention this’ll garner among casual market observers (“laypeople,” if you like) but if you’re looking for funding canaries or evidence to support the notion that the liquidity tide is on its way out, a sharply higher SOFR print will fit the bill.
The 6bps jump reflected in Friday’s fix raised a few eyebrows Monday, particularly given that it came after month-end.
This is the sort of thing that’s easy to sensationalize (e.g., Cameron Crise’s “monster fix” characterization and subsequent contention that “the liquidity narrative has become a lot less friendly in a hurry”) and while I want to avoid that, I don’t want to be derelict by not mentioning something that could potentially become a bigger story.
In straightforward terms, “funding volatility is show[ing] signs of life,” as Nomura’s Charlie McElligott put it. His colleague Ryan Plantz, editorializing around the situation, wrote that although SOFR will probably normalize in the days ahead, “the absolute level of funding volatility” is likely to rise, exerting more upward pressure. “Simply put, you are starting to see some of the implications of QT as well as sponsored repo coming home to roost,” Plantz said.
Sponsored repo isn’t as demanding from a balance sheet perspective, but as renowned funding expert Alonzo Harris put in the celebrated Wall Street drama Training Day, “There’s nothing free in this world, Jake.” The FICC intermediary means banks don’t have to hold as much capital (i.e., dealers have more available balance sheet to extend), but it’s not costless.
SOFR is volume-weighted, and as the figure below shows, FICC delivery-versus-payment is chewing up more of the volume:
That’s sponsored repo, and as Plantz noted, “not many of the costs… have been passed on up until this point [but] they have started to steadily increase consistent with the volumes in the product itself.” The question, then, is whether we’re starting to see those costs filter through.
It’s interesting, Plantz went on, that the spike played out against a backdrop of crowded Treasury positions (he mentioned hedge funds’ basis trade). “We think this is likely playing a part in the most recent phenomenon we have seen on Friday’s fixing and is unlikely to subside in a big picture sense as we now look ahead to year-end,” he added.
Barclays’ Joseph Abate said the Treasury rally led to increased demand for secured funding in excess of what dealers were able to immediately supply, leading to the SOFR surge. If you ask Abate, it’ll take a few days for dealer balance sheets to adjust, which could mean SOFR trades over Fed funds through mid-week.
Obviously, the persistence of QT will exacerbate nascent funding issues to the extent they exist. “The advent of sponsored repo has only masked the problem that will potentially rise if dealers are forced to pass on the costs of clearing repo back to end users,” Plantz said Monday. “This seems to be starting to happen more and could be meaningful for the clearing level of funding.”