The risk of a squeeze in US funding markets is increasing as the yield curve bear steepens, i.e. longer-term yields rise more than short-term ones. More attractive bill yields and climbing interest-payment costs on government debt are depleting reserves and reducing their velocity, increasing the chance of a disorderly upswing in funding rates, as well as posing a risk to the stock market.
The bond market intimidates everybody, in the oft-cited words of Bill Clinton’s chief strategist James Carville. That description is apt today as rising yields reverberate across the financial system. Funding risks are intensifying again, increasing the chance of a rate-volatility driven correction in stocks.
Concerns about funding issues have been in abeyance for most of this year, but it is time to sit up and take notice again as the backdrop becomes more pernicious. The bear steepening of the yield curve is a double whammy, accelerating the rate of reserve depletion through a declining reverse repo facility (RRP) and rising government interest payments.
The curve has been bear steepening in the 3-12 month versus 10-year sectors as inflation fears drive term premium higher, with the measure now close to levels last seen in 2008 (using tradeable forward OIS rates rather than “academic” term premium).
A bear steepening is particularly problematic in the current set-up.
First note that the RRP has been hugely important in keeping risk assets supported despite the fastest rate-hiking cycle for decades and ongoing QT.
The Treasury’s decision to pivot issuance toward short-term bills allowed money market funds (MMFs) to tap the more than $2.5 trillion liquidity idling in the RRP to fund the government. That prevented enormous public issuance crowding out other assets, and allowed the rally in stocks and bonds to continue.
But the RRP falling and eventually going to zero is a harbinger total reserves overall are potentially nearing their so-called lowest comfortable level — with estimates for the LCLoR ranging from about $2.5 to $3 trillion — where abrupt and acute funding problems become more likely. This week the domestic RRP fell as low as $327 billion, and is now at $440 billion, the lowest levels it has reached since June 2021, taking the sum of reserves and the RRP to just over $4 trillion.
The RRP has been declining as six-month and 12-month bill yields have been rising in response to the market reducing the number of rate cuts expected from the Fed, making bills more attractive to MMFs relative to the RRP facility.
Some of the RRP’s recent fall has also likely been driven by seasonal tax payments. But that should not mask the clear downwards trend in the facility and its rising volatility. It would not be the first time that a telegraphed non-risk becomes a real risk precisely because peoples’ guards are down.
That’s potentially the case today. As I noted in a column earlier this year, a portent of previous funding episodes was a sharp drop in funding volumes immediately preceding a rapid rise in them, similar to a tsunami wave. As the chart below shows, when the total amount of reserves + RRP declines, volumes in fed funds (i.e. reserves) tend to also decline.
Further falls in fed funds volumes would be a sign that funding problems are potentially fomenting.
Rising longer-term yields are the other side of the coin in the bear steepening. The US government’s interest-rate bill is climbing rapidly, and is now over $1 trillion on an annual basis. This is set to grow much higher.
The 10-year yield gives us a near real-time barometer for the US’s annual interest expense. The recent rise in yields projects the expense will soon double to almost 5% of total debt outstanding, or over $1.7 trillion - i.e. about the GDP of Australia each year in interest.
Here lies the rub: to pay that interest, the government needs to tax and borrow. But that is an ever-greater drain on reserves and their velocity, accentuating the effects of the Fed’s ongoing QT program.
You might ask why that is the case given the interest is paid to bond holders and is therefore re-injected into the economy?
But that’s unlikely to be so for two reasons.
The first is that the corporate and household sectors, the two most likely to spend interest back in the domestic economy, together only account for about 10% of UST holdings. The much larger financial and foreign sectors are more likely to save the proceeds, or spend them abroad.
Second, reserves that end up as savings are of lower velocity, especially if they were originally higher-velocity bank deposits used to pay taxes. The more that interest payments percolate through the system, the more they end up with holders who have an increasingly lower propensity to spend them.
Thus a bear steepening squeezes the RRP and outstanding reserves — as well as their velocity — in a pincer movement, increasing the risk of a funding episode.
The last such major squeeze was in September 2019. It’s notable that in the days running up to that, the yield curve was bear steepening (in fact, it was in the top 1% of eight-day rises for the 2s10s curve going back 2000).
The bear steepening therefore means we should once again be vigilant to funding risks, and keep a close eye on the Funding Stress Trigger shown below.
The signal is inactive at the moment and the SOFR rate is currently well-behaved, but that can change quickly. In the last two major funding flare ups in 2018 and 2019, there were very few signs of what was to come, with the signal triggering only a few days before rates started to spike higher.
Funding stress would also be likely to increase rate volatility, which in turn would lead to higher stock-index correlation. That means a higher VIX, increasing the likelihood of a market correction as the stock perpetual motion machine shudders to a halt.
The potential risks, of course, may not come to pass, and funding markets continue to operate smoothly. But there are enough ex ante reasons to justify heightening one’s senses. The bond market may be intimidating, but a bear-steepening yield curve in the current market set-up is especially menacing, and should be watched closely.
