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Is Repo Volatility Contributing to a Flight to Quality? Unusual Changes in Overnight Rates Could Have Broader Effects

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Is Repo Volatility Contributing to a Flight to Quality? Unusual Changes in Overnight Rates Could Have Broader Effects T. ROWE PRICE INSIGHTS ON U.S. FIXED INCOME Is Repo Volatility Contributing to a Flight to Quality? Unusual changes in overnight rates could have broader effects. October 2019 KEY INSIGHTS ■■ Technical factors are creating volatility in money markets, which we believe could be a contributor to the recent flight to quality in both bonds and stocks. Christopher Brown, CFA ■■ We think that the Fed could eliminate much of the volatility by establishing a Lead Portfolio Manager for permanent repo facility to add reserves via the central bank’s balance sheet. Total Return Bond Fund ■■ The Federal Reserve’s action—or lack thereof—to permanently address this issue will inform our risk asset positioning in the Total Return Bond Fund. Adam Marden he well‑publicized mid‑September the seemingly conflicting signals sent by Multi‑Asset Investment Analyst spikes in overnight lending stocks and bonds. In a sign of a positive Trates illustrate how technical economic outlook, equities had broadly factors are creating volatility in some climbed for the year to date. However, money market instruments, which Treasury yields were simultaneously we believe could be a key contributor plummeting and sections of the yield to the recent flight to quality in both curve were inverting, signs that bond fixed income and equity markets. The investors feared a near‑term recession. Federal Reserve has not yet committed to taking measures to permanently Looking a little closer, however, we address the unusual volatility in noticed a flight to quality in both short‑term lending markets. The central markets. This year’s stock market rally 1 bank’s action—or lack thereof—on has featured low‑beta, defensive stocks this issue will inform our risk asset easily outperforming cyclicals. In the positioning in the Total Return Bond fixed income markets, Treasuries and Fund going into the end of the year. investment‑grade corporates have outpaced high yield bonds. More recently, Bonds, Stocks Seem to Send within the investment‑grade corporate Conflicting Signals sector, the spread between credit quality In late August, portfolio managers from yields has widened as AA rated debt has T. Rowe Price’s Fixed Income, Equity, outperformed BBBs. In high yield, BB and Multi‑Asset Divisions met to discuss rated securities have outperformed CCCs by a wide margin. 1 Beta measures the volatility, or risk, of a stock relative to the risk of the broad market. 1 Attractive Overnight Lending Rates is another factor. The Treasury has had May Drive Flight to Quality to increase its debt issuance to fund the There have also been unusual deficit. Primary dealers have to buy any USD 1 developments in the typically quiet new Treasury supply not absorbed by money markets. A confluence of bidders at auction, which removes more technical factors had been driving reserves from the banking system and Trillion volatility in low‑risk overnight lending increases demand for financing. rates meaningfully higher even before Repo Rates Spike in September 2019 budget deficit the spikes in September. We believe through August. the unsettling nature of this volatility to In mid‑September, quarterly corporate market participants, as well as the relative tax payments were due to the Treasury, attractiveness of these safe short‑term which temporarily removed even more investments, was likely drawing demand liquidity from the system. This caused away from the riskier segments of global repo rates to spike as high as 10% and financial markets, contributing to the flight the federal funds rate to briefly exceed to quality that we have been observing. the top of the central bank’s target range, prompting the Fed to temporarily add Banks and some other financial reserves by conducting repo operations. institutions fund their longer‑term The elevated overnight rates may have investments in the overnight lending exceeded the returns that institutions market, which is essentially the anticipated earning on their longer‑term “plumbing” of the financial system. Much investments, dampening demand for of this lending is through repurchase riskier assets. agreements (repos), which are short‑term loans collateralized by U.S. government While overnight lending rates rose securities. Institutions needing cash can steeply in the midst of the global financial sell these high‑quality assets to banks crisis, it is important to note that we do that have reserves to lend, agreeing to not view the recent repo spikes as an repurchase them the next day at a slightly indicator of systemic problems. Unlike higher price that provides a small return 2008 and 2009, the recent repo volatility to the lender. When demand for funding is technically driven and not related exceeds reserves available for lending to concerns about the solvency of the in the repo market, the rate can spike— banking system. which has the same effect on liquidity as Potential for More Market Volatility a clogged pipe in a house. in Fourth Quarter Various Factors Clogging the For regulatory reasons, banks typically Banking System’s “Plumbing” become less active in using their Several factors have coincided to drain balance sheets for repo as year‑end reserves from the banking system. As approaches, setting up for even more the central bank shrinks its balance volatility in the overnight lending market sheet, the Fed has stopped buying in the fourth quarter that could affect Treasuries to inject reserves. Also, as a other markets. However, we think result of regulatory capital requirements that the Fed could eliminate much of implemented after the global financial the repo volatility by establishing a crisis, primary dealers2 are now less permanent repo facility to add reserves willing or able to use their balance sheets via the central bank’s balance sheet to supply liquidity. when needed to cap rates. In a step in that direction, Fed Chairman Jerome The expanding budget deficit, which Powell referred to the volatility in fiscal stimulus has driven to over overnight lending markets in his press USD 1 trillion for 2019 through August, conference following the September 2 Banks that can buy and sell securities directly with the Federal Reserve. 2 policy meeting, reassuring markets that the fourth quarter. We would limit the the central bank is aware of the issue. portfolio’s risk exposure as we would If the central bank expect demand for riskier fixed income The Fed could also bring overnight rates segments to be negatively impacted by continues along down by aggressively cutting the fed ongoing “plumbing” issues. funds rate, steepening the yield curve, the path toward a although that method would not be as However, after the repo rate volatility in permanent repo direct as implementing a permanent mid‑September, the Fed committed to repo program. Also, to be successful, conducting temporary overnight and term program, all else the central bank would need to commit operations through mid‑October. If the to significantly more rate cuts than central bank continues along the path equal, we would policymakers have signaled in recent toward a permanent repo program, all be more inclined to communications. Considering the Fed’s else equal, we would be more inclined to current assessment of the economy, we add risk. Currently, we see value in bank add risk. view this as unlikely. loans and securitized credit and would likely favor these areas. Additionally, a If the Fed does not firmly commit to a calming of the recent “plumbing” issues, more permanent solution to the recent along with continued solid economic repo volatility, we would position the Total data, would be supportive of a steeper Return Bond Fund for more volatility in yield curve. WHAT WE’RE WATCHING NEXT Because bond markets can provide important signals and information about equities, and vice versa, we will continue to collaborate with T. Rowe Price’s portfolio managers and investment analysts across the full range of asset classes. For example, we consulted with the firm’s commodities and currencies analysts when evaluating the impact of the September 14 attacks on Saudi Arabia’s oil production facilities and the ensuing volatility in oil prices. 3 T. Rowe Price focuses on delivering investment management excellence that investors can rely on—now and over the long term. To learn more, please visit troweprice.com. Important Information Call 1‑800‑225‑5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing. This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are those of the authors as of October 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates. The fund is subject to market risk, as well as risks associated with unfavorable currency exchange rates and political economic uncertainty abroad. This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only. T. Rowe Price Investment Services, Inc. © 2019 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T.
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