(Bloomberg) -- A rise in funding costs is spilling into the market for repurchase agreements backed by equities, a phenomenon that’s unlikely to abate, according to JPMorgan Chase & Co.
The amount of equity collateral that dealers need to finance the repo market has swelled, driven by the benchmark S&P 500 Index rallying to new highs and robust investor demand for leverage equity exposure, said strategists Teresa Ho, Pankaj Vohra and Bram Kaplan in a note on Wednesday. As a result, the total amount of primary-dealer equity financing in repos has hit the highest level since April 2013, according to the most recent Federal Reserve Bank of New York data.
This comes as dealer balance sheets are already congested, creating turbulence in the US Treasury-backed repo market. The combination of ballooning marketable debt and a Fed that is no longer buying as much government securities as part of its own balance sheet unwind— a process known as quantitative tightening — means there’s more collateral that needs to be financed. And, as QT continues to drain liquidity from the financial system, it’s also putting more strain on dealers to intermediate liquidity when capacity is limited.
At the end of September, banks retreated from the repo market to shore up their balance sheets for regulatory purposes, sending the rate for general collateral to 5.90%. The Secured Overnight Financing Rate, or SOFR — an important one-day lending benchmark linked to activity in the repo market — fixed above the Fed’s interest on reserve balances rate for a few trading sessions.
All this is “expected to be amplified over year-end when balance sheet constraints tend to be most restrictive from a regulatory perspective,” the strategists said. “While year-end balance sheet pressure may fade in the new year, there is still the issue of client positioning.”
In the equity market, asset managers are at record longs while dealers are at record shorts, which suggests strong demand for dealers’ balance sheet, according to JPMorgan.
Absent an equity market selloff, “these pressures will persist, with dealers having to continue to fund an increasing amount of equity collateral pushing financing costs higher,” strategists said.
Even though the prospects of potential market deregulation under the Trump administration could help alleviate balance-sheet pressures, they added, this will take time due to personnel changes and the rulemaking process.
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