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One of the more low-key but intriguing conversations in markets today concerns the wild divergence in short-term funding costs for the US equity and bond markets.
Short-term money market interest rates are now well-behaved again, thanks in part to the Federal Reserve’s “reserve management purchases”. As you can see below, sundry repo rates like SOFR are within the US central bank’s interest rate corridor despite the approaching quarter-end — when money typically gets a bit tight.
This is good news. If there’s one market where we don’t want any accidents, it’s the repo market — which finances the vast majority of the now-huge Treasury holdings of hedge funds.
However, the cost of short-term repo financing for equity positions has climbed sharply lately, and that’s becoming a worry for some analysts.
Here are two charts from Morgan Stanley’s analysts that show CME’s “Adjusted Interest Rate” futures on the S&P 500’s total return index. Basically, these show the extra cost of leveraged investments in US stocks above benchmark interest rates. And as you can see, things have got a bit weird lately:
“Record equity financing costs, measured by AXW futures, reflect a growing imbalance between the demand for levered long equity exposure and dealer balance capacity,” Morgan Stanley’s analysts wrote in a note on Friday.
So what does this actually mean? Well, there seems to be so much ravenous demand for leveraged US equity investments — especially in hot AI and AI-adjacent sectors — that it’s causing short-term funding markets to bifurcate.
But in the post-2008 regulatory world, banks don’t have infinitely expandable balance sheets. There are all sorts of capital requirements they need to meet, and no bank wants to get pushed up the ranks of the Global Systemically Important Banks list and get hit by even higher charges. Moreover, regulatory frictions mean that banks can’t easily shuffle lending capacity from the fixed-income business to the equity market business.
Morgan Stanley also obliquely notes that “a large liquidity event two weeks ago only made the GSIB-related balance sheet management process into quarter-end more complex” . . .
In case you missed it, Morgan Stanley helped take SpaceX public a couple of weeks ago in the biggest, most hyped IPO in history.
Aaanyway, the combination of an increasingly leveraged stock market rally and finite funding availability means that costs have had to rise. But that could cause problems around the quarter-end cash crunch, as the analysts a bit more forthcomingly note:
. . . . If financing costs are too prohibitive, they may ultimately limit the ability of levered investors to further increase gross exposure. In that scenario, a market that has benefited from financing-supported demand could become more vulnerable to deleveraging.
We think risk of a tumultuous quarter-end that produces a deleveraging event has risen, following the market reaction to earnings in the semiconductor sector this week. This subsector of the market is one where hedge fund levered long equity exposure has become more and more concentrated over the past year.
Given close proximity to quarter-end, prime brokers may become increasingly conservative with balance sheet provision in order to avoid entering the next GSIB surcharge bucket. For hedge funds, this means less financing availability and more prohibitive pricing.
OK, maybe this needs to be simplified a bit more. In normie speak, the stock market has got hooked on morphine. But as it keeps growing it needs more and more morphine to stay happy. Unfortunately, its dealers are running a bit low on morphine at the moment, and can’t easily procure more supply because of a government crackdown. That could mean a really nasty comedown if the stock market has to subsist on a smaller dose of diluted morphine this week.
Of course, the mere fact that this is now being highlighted tends to minimise the chances of a major accident. There have often been concerns around the ends of quarters and years when money has been tight, but the better telegraphed a thing is, generally the less likely it is to cause problems. Crying wolf can actually work.
Moreover, funding conditions should improve once we get over the quarter-end hump this week. Some banks’ equity repo capacity might have been tied up in large IPOs (hello, SpaceX) and index rebalancing trades (again, hello SpaceX), and this capacity should soon be freed up again.
However, even if we do avoid a repo-triggered stock market accident, equities keep marching higher, and demand for equity repo financing stays strong, then it could cause problems for the US Treasury market.
After all, if equity repo rates remain elevated then banks could be tempted to shift some of their balance sheet capacity from bonds to stocks, Bank of America’s analysts warn:
Equity financing needs risk crowding out dealer [fixed income] funding capacity. Stable to modestly easy [US Treasury] funding conditions suggest limited impact of any crowding out thus far. If equities keep rising & drive up funding costs, crowding out risk will grow.
