BOE Warns Weekly Fund Redemptions Of 1.3% Would Break Corporate Bond Market

The Bank of England has done some timely and truly eye-opening research into the resilience of corporate bond markets. The research is contained in the Bank of England Financial Stability Paper No.42 and is titled “Simulating stress across the financial system:  the resilience of corporate bond markets and the role of investment funds” by Yuliya Baranova, Jamie Coen, Pippa Lowe, Joseph Noss and Laura Silvestri.

The starting point of the analysis is to revisit the Global Financial Crisis (GFC) which saw $300 billion of related to subprime mortgages amplified to well over $2.5 trillion of write-downs across the global financial system as a whole. One of the problems was that the system was structured in a way that did not absorb economic shocks, but amplified them. The amplification came via a feedback loop. As the crisis unfolded, fears about credit worthiness of banks led to the collapse of interbank lending. Weaker banks had their funding withdrawn, which led to a downward spiral of asset sales and the strangling of credit in the broader economy.

The paper notes that, since then progress has been made and the Bank of England’s stress tests now include the feedback loop created by interbank loans.

Indeed, the 2016 test showed that the potential for solvency problems to spread between UK banks through this channel has “fallen dramatically” since the crisis. Furthermore, interbank lending has been cut back and is more often secured against collateral.

The report cautions that other feedback loops might be present, especially since banks only account for about half of the UK financial system. Indeed, a key objective for regulators is to assess how the non-bank part of the system – termed “market-based finance” in the paper, responds to economic shocks. In particular, could the non-bank system, which trades “market-based finance” (principally bonds), amplify shocks in a similar way to the banking system during the last crisis? The report characterises market-based finance and the related risks as follows.

The system of market-based finance includes, among other parts, investment funds, dealers, insurance companies, pension funds and sovereign wealth funds. It supports the extension of credit and transfer of risks through markets rather than banks. It has expanded rapidly since the crisis.  At the global level, assets held by non-bank financial intermediaries increased by more than a third since the financial crisis. The potential spillover effects in market-based finance centre on ‘fire sales’ of assets, which affect prices of financial assets and functioning of markets.  Participants in this part of the system can face incentives, or be forced into, sudden asset sales.

The report sees the potential for another dangerous feedback loop developing from falling asset prices which lead to declines in net worth, prompting a withdrawal of funding which leads to more asset sales and further falls in prices. They are hardly reinventing the wheel here and what they’re really describing is the evidence that investors often behave pro-cyclically. It raises the valid concern that pro-cyclical behaviour is most dangerous in less liquid assets with short-notice redemption – the classic liquidity mismatch. The post-Brexit problem in 2016 in UK commercial property funds was a great example.

These dynamics were illustrated clearly in 2016 in funds investing in UK commercial property.  With the property market in hiatus following the United Kingdom’s referendum on membership of the European Union, these open-ended funds faced redemption requests from investors concerned about the prospect of future price falls and fearing that other redemptions would force the funds to suspend.  The process was self-fulfilling and many funds were forced to suspend redemptions.

The report goes on to highlight the challenges for broker-dealer liquidity and hedge funds if asset managers aggressively sell securities in a crisis. It’s obvious stuff, i.e. that broker-dealer are less able to warehouse securities and less able to provide funding to hedge funds, which might be buyers, and could become forced sellers. The BoE models what would have when one type of shock - redemptions by open-ended funds - trigger selling by the funds with spillover effects for broker-dealers and hedge funds.

The paper that follows seeks to model how the aggregate behaviour of several sectors within the system of market-based finance, including investment funds and dealers, could interact to spread and amplify stress in corporate bond markets.  That focus stems from the growing importance of bond markets to the financing of the economy, alongside the rapid growth in holdings of such bonds in fund structures.  It does not focus on individual companies; the analysis is conducted at a sector level.  It is not concerned with the capacity of the sectors to absorb losses.

Basically, the model estimates the sensitivity of investment grade corporate bonds yields in Europe if funds sell the equivalent of 1% of their total assets on a weekly basis – which was similar run rate to the redemptions in October 2008 (4.2% over the month – see below). Since then, however, broker-dealer capacity has contracted and investment grade issue issuance risen sharply. Importantly, it also addresses the scale of redemptions which might overwhelm the ability of broker-dealers and hedge funds to absorb the selling. The model assumes that there is a shock leading to an initial round of redemptions which prompts investment funds to make asset sales. Broker-dealers require lower prices to compensate them for absorbing the selling which leads to a second round of redemptions and selling. After that, further selling “breaks” the market and leads to dislocated prices on the downside.

 

The paper explains the market-breaking points as follows.

The level of redemptions at which the second-round price impact line ends is where dealers reach the limit of their capacity to absorb those asset sales by funds not purchased by hedge funds.  We assume that market liquidity is tested at this point and refer to it as the market-breaking point. Transactions could still occur beyond this point — for example, if a dealer can immediately match a buyer and seller or if it sells other assets to purchase corporate bonds — but are assumed to take place at highly dislocated prices.  

Conclusion:
The BoE paper estimates that a weekly level of redemptions from funds equivalent to 1% of their assets would increase investment grade corporate bond yields by 40 basis points. However…this is the key…it estimates that initial redemptions equivalent to only 1.3% of assets on a weekly basis would be “needed to overwhelm the capacity of dealers to absorb those sales, resulting in market dysfunction”, i.e. the market-breaking point. It describes this as an “unlikely but not impossible event.”

We disagree, we are in a far bigger bubble than 2007-08.

Hong Kong Interbank Rates Spike To Highest Since Lehman

For only the third time since Lehman, the price of liquidity in the Hong Kong Dollar interbank markets has exploded higher.

Overnight HKD Hibor soared over 60 basis points to 0.71407% in Monday trading - the highest since October 2008...

Note that the two previous spikes were around year-end, so this is unusual in both its velocity and size.

Of course, the narrative of a panic in Asian liquidity is not a good one for supporting risk assets and so the spike is being dismissed as a one-off due to several factors (as Bloomberg reports)...

Monday’s rise in Hong Kong dollar overnight interbank rate was due to major fund providers being more cautious in lending at month-end, and because of demand from some market players, a Hong Kong Monetary Authority spokesperson writes in an emailed reply to questions from Bloomberg. Interest rates subsided when fund providers responded by lending out more Hong Kong dollars. Relatively large movements in short- dated interest rate Monday was probably a result of thin market conditions ahead of the month-end. The market continued to function normally.

Monday’s sudden spike in HKD overnight funding cost is probably due to short-term funding activities, likely for I Squared Capital’s purchase of Hutchison Telecom’s unit and HSBC share buyback announcement, says Angus To, deputy head of research at ICBC International Research.

Rate likely to drop soon as HKD liquidity remains ample in general, To says in a phone call.

So just ignore the fact that the HKD liquidty markets just exploded due to month-end (well it hasn"t before - see chart) and some M&A (there"s been no M&A in the last 9 years?)... it"s probably nothing.

Morgan Stanley: "Market Is So Distorted" The Fed Is Being Forced Into A "Pain Trade"

Add Morgan Stanley to the list of banks who are lashing out against the Fed"s interminable easy monetary policy (as we pointed out last week, the most notable recent entrant was Bank of America which had a simple message to Yellen: "Take That Punch Bowl Away").

In a note from Morgan Stanley"s Hans Redeker, which attempts to explain the Fed"s increasingly cautious message on risk prices (incidentally, the same as Goldman which just yesterday cautioned that it was "Troubled By The Fed"s Growing Warnings About High Asset Prices") the bank"s FX strategist writes that "by now markets have become too distorted."

Picking up where Goldman started back in March, when the bank lamented the disconnected between the Fed"s rate hikes and easier financial conditions, Redeker writes that DM central banks collectively turning towards a more hawkish stance "leaves the impression of a coordinated approach, explaining the market"s reaction which saw bond yields rising at the quickest pace since autumn last year (when investors put their money on the ‘Trump boom" which eventually failed to emerge)."

Echoing Citi"s ongoing observations, Redefeker then observes that this time, unlike in 2015, "rising bond yields only led to a small risk dip from where markets quickly recovered once it became clear that central banks may lean against financial conditions, but have no interest in pushing markets over the edge by overly tightening conditions. It is the low level of current and anticipated inflation which suggests that central bank tightening is not inevitable at this stage. It is, instead, an option, which central banks are willing to exercise should financial conditions stay supported from now."

This too is nothing new as money market participants "have consistently bet against the Fed dots, hoping that US monetary authorities would have to capitulate in front of markets once again."

To be sure, so far there is no indication to suggest that the market will be wrong in its "standoff" with the Fed, which as Kevin Muir described on Friday, is a classical dare by traders, one which they are convinced they will win as Yellen blinks again. Redeker describes this dynamic as follows:

For several years, markets have undergone this ritual with an over-optimistic Fed eventually acknowledging the power of deflationary forces. Too often, it was the strength of the USD transmitting global deflationary pressures into the US.

However, this time there may be a twist: "USD weakness and abating global deflationary pressures may have sharply improved the chances of the Fed getting it right this time."

And yet, another problem emerges: according to Morgan Stanley, "by now markets have become too distorted" as "financial conditions have further improved and despite the Fed and other central banks warning against misallocation risks, the US opportunity cost of capital as expressed by the 10-year term premium has only adjusted a little. The gap between the term premium and financial conditions has become substantial (Exhibit 2). At the same time the USD has stayed offered, not taking notice that the term premium no longer trades at the low June levels. The DXY and the term premium have diverged, which either suggests the USD will rally or the term premium will ease back again (Exhibit 3)."

This is a segue to another curious observation: "While central banks may now act at a faster pace compared to previous expectations, this has failed to undermine risk appetite. This does not only suggest that markets are in broad agreement with monetary authorities over withdrawing accommodation, it may also suggest that there are alternative sources of liquidity funding the current risk bull run."

Morgan Stanley did not have any suggestions as to what this "alternative source of liquidity" may be, however whatever it is, it may be the source of the relentless risk bid that the Fed now finds itself up against.

But going back to the original dynamic, Redeker notes that "markets seem to be assuming that a positive risk environment may require the Fed to capitulate to markets. This is why investors are positioning for yield curve flatness, pushing the volatility curve into steeper territory, and are willing to pay unusually high premiums for out-of-the-money put options on equity indices. In other words, a high wall of worry has gone up (Exhibit 4). Concerned markets rarely turn into full bear markets. We may need to get into a ‘this time is different" mentality of buying everything today before a bigger bear market sequence emerges. In addition, in the past, long-term stability concerns may have been fed by a stronger USD, next to other factors. The USD has weakened over the course of the past six months, which should ease some concerns provided that past relationships still prevail."

And this is where the unexpected turn may come. Here is Morgan Stanley"s summary why the Fed may have no choice but to push the market into a "pain trade"

Central banks leaning against booming financial conditions. When some DM central banks collectively turned around to express a tighter approach, markets were unprepared as investors focused on undershooting inflation and uncertainty. Exhibit 5 shows the divergence between how often the word "uncertainty" appeared in economic commentaries and market pricing of equity volatility (VIX). It is liquidity feeding into lower volatility, keeping financial conditions supported and pushing valuations higher. Indisputably, ambitious asset valuations bring long-term deflation risks should asset bubbles burst. Central banks tend to lean against this risk.

Accordingly, continued easy financial conditions may push the Fed into action. Should this outcome materialize, a "pain trade’ may emerge. Reluctant and hence cash-holding investors would find themselves running insufficiently low risk exposures, and participants hoping the Fed would capitulate to markets may see the central bank staying on course to deliver according to its dots. A reactive Fed operating closer to  its dots and risk markets staying supported for now would represent a very different outcome compared to current positioning.

Alas, we have heard all of this before, and while we agree with Redeker, it is up to Yellen to confirm that at least this one time the Fed isn"t bluffing...

Qatar Is Running Out Of Dollars

While the Saudi-led campaign to starve Qatar"s citizens may end up short of the target, with both Turkey and Iran volunteering to provide needed staples to the isolated Gulf nation while local entrepreneurs have started a cow paradropping campaign to offset the decline in milk imports, a more pressing problem has emerged: Qatar"s financial system is running out of dollars. As Bloomberg reports, several Qatari banks have boosted interest rates on dollar deposits to shore up liquidity as the Saudi-led campaign to isolate the gas-rich Arab state intensifies.

To boost their hard currency reserves, Qatar banks are now offering a premium of as much as 100 basis points over LIBOR to attract dollars from regional banks, some 80 bps higher compared to the rate they offered prior to last week"s crisis. A similar picture is visible on the 3-Month QIBOR, or Qatar Interbank Rate, which has surged to 2.3% as of Tuesday.

According to the central bank, at the end of April, Qatar"s banks held 21.4% of their customer deposits in foreign currency. Non-resident deposits made up 24% of the overall deposits of 781 billion riyals ($213 billion). A separate estimate from SICO Bahrain, Qatari banks have around 60 billion riyals ($16.5 billion) in funding in the form of customer and interbank deposits from other Gulf states. Most of this could eventually be withdrawn if the crisis continues.

Adding to concerns of a monetary blockade, Bloomberg also reports that some banks in neighboring countries have been cutting their exposure to Qatar amid concerns of a widening of the blockade.

In a Tuesday report, Capital Economics" Jason Tuvey wrote that while banks are unlikely “to be thrust into a crisis,” borrowing costs “look set to rise and banks are likely to become more cautious with their lending,”  “If local banks struggle to rollover their external debts, they could be forced to shrink their balance sheets and tighten credit conditions." For now the local central bank has said that Qatar"s banking system is functioning without disruption, although market indicators suggest liquidity stress is rising. Likewise, Qatar National Bank, the biggest lender in the Middle East, said it didn’t see any “significant” rate increases since the standoff began, according to statement emailed to Bloomberg on Tuesday.

The good news for Qatar - the world"s wealthiest nation on a GDP/capita basis - is that it has enough financial firepower to withstand a prolonged financial siege, and defend its currency and economy, Finance Minister Ali Shareef Al Emadi told CNBC in an interview broadcast Monday. Al Emadi played down the impact of the crisis on the country, saying the plunge in Qatari assets last week was a “normal” reaction to the standoff.

While so far there has been no suggestion that Qatar would commence liquidating its reserves, investors have already begun selling Qatari assets and speculating against the riyal, concerned how long Qatar can weather the crisis without having to devalue its currency or sell any of its global holdings. Qatar’s 12-month riyal forwards closed at 588 basis points against the dollar on Monday, the highest level since at least 2001, according to data compiled by Bloomberg. Rates eased slightly to about 500 basis points on Tuesday.

Despite the spike in interbank rates, S&P is confident that Qatari banks are strong enough to survive the pullout of all Gulf money and then some. The ratings agency ran two hypothetical scenarios of capital flight, and concluded that Qatar’s lenders could survive the withdrawal of all Gulf deposits plus a quarter of the remaining foreign funds the banks keep. Still, that did not prevent S&P from lowering Qatar’s long-term rating by one level to AA- last week.

Separately, Reuters reports, that the dollar shortage has also spread over to money exchange houses in Qatar on Sunday, making it harder for worried foreign workers to send money home.  

"We have no dollars because there is no shipment or transportation from the United Arab Emirates. There is no stock," said a dealer at the Qatar-UAE Exchange House in Doha"s City Center mall. "The shipment is blocked from the UAE" the dealer added, although it was not quite clear if it was physical cash that was being transported.

Other exchange houses in Doha also told Reuters they had no supplies of dollars. At Qatar-UAE Exchange, dozens of people - some of the foreigners who comprise nearly 90 percent of the population of 2.6 million - waited quietly in line to change money or make remittances to their home countries.

"I spoke with my wife this morning. She said, "Send your savings to me now." I am not panicked but my family are scared," said John Vincent, an air-conditioning repairman from the Philippines.

"I sent 2,000 riyals ($550) home but I have some more savings left here in Qatar. I will see what the situation is in coming days before I decide what to do."

Sudhir Kumar Shetty, president of UAE Exchange, which has eight branches in Qatar, said his firm was continuing to handle remittances and currency buying as usual in that country. He said the firm hadn"t seen any major change in remittance volumes due to the diplomatic tension.

But he added that dollar supply was not meeting demand in Qatar and attributed this partly to flows of the U.S. currency from other Gulf countries being disrupted.

"Everywhere, all the banks and exchange houses, there are no dollars. All the exchange houses are trying to get currencies from other countries," the dealer at Qatar-UAE Exchange said, adding that his firm was hoping for a shipment from Hong Kong.

For now most Western banks with a presence in Qatar have continued business as normal, partly because they did not want to lose out on billions of dollars of building projects which Qatar plans before it hosts the soccer World Cup in 2022.  But other Western banks have halted new Qatar business including interbank and syndicated lending, while continuing to service existing business, banking sources said, declining to be named because of political sensitivities.

"Everybody is shocked - they"re not worried about Qatar"s credit, they"re worried about compliance and the risk that the local sanctions could be escalated to an international level," said one foreign banker in the region.

In a worst case scenario, bankers expect Qatari banks to borrow from the central bank"s repo facility if they become short of funds. However, central bank rules limit the size of the repos to 2% of each bank"s private sector deposits. Bankers speculate the central bank may lift this cap although the central bank did not respond to Reuters requests for comment.

Crisis Meet China - China Meet Crisis

By Chris at www.CapitalistExploits.at

Earlier this week, Kyle Bass spoke on Bloomberg about the reckless expansion of the credit system in the Middle Kingdom.

He warned about the ballooning asset-liability mismatch in the shady $4-trillion wealth management products (WMPs) market.

And went on to say "this is the beginning of the Chinese credit crisis" while admitting it could take some time for things to really start unraveling.

A fair call...

How many of us have figured the trend out, only to allocate too much capital to a trade and even lose on a trade which finally works... eventually? I know I have. I"m pretty sure Kyle"s position sized pretty well. After all, this is far from his first rodeo.

In the interview Kyle referenced an SCMP article from a few weeks ago that went largely unnoticed by most. It was on the Chinese government coming up with more and more creative ways to stem the capital outflow underway since mid-2014:

"China"s foreign exchange regulator, SAFE, has asked for cooperation from multinationals, including Sony, BMW, Daimler, Shell, Pfizer, IBM and Visa, to manage and control the flow of capital out the country."

This all feels a bit deja vu-ish.

Long-time readers will know we"ve been bearish on China and the renminbi for well over 2 years now. Back in October 2014 we said that:

"I don’t know exactly how a breakdown in the renminbi will play out. However, it is a sure bet that all those markets that prospered over the last 15 years or so on the back of a China will do badly. Where things become shady is the collateral damage to other markets that have had nothing to do with the Chinese economic miracle."

A few months later, we took a closer look at the cracks appearing in China"s interbank lending market, indeed feeling (correctly in hindsight - lucky us) that timing had arrived to short the currency cross via the options market:

"The interbank lending market is an integral part of any country’s banking system as it is where banks maintain their short-term liquidity requirements. Often a bank will have a mismatch between between short-term assets and obligations and as such they will have to enter the interbank lending market to maintain optimal liquidity. If a bank has excess short-term reserves they may want to lend these out to other banks who have a shortfall in short-term reserves. The opposite also occurs where a bank, with a short-term funding deficit, will enter the market to borrow funds to match short-term liabilities.

The behavior of the interbank lending market can provide one with a good appreciation for the liquidity of the banking system as a whole. If there is a lot of liquidity in the system (more short term assets than liabilities) the interbank rate will fall, if there is scarcity of short term assets relative to liabilities then rates will rise. So a rising interbank rate is generally associated with contracting liquidity conditions. Rapid rises in interbank lending rates are often associated with banking or credit crisis. This happened in the lead up to the GFC. What happened was that as banks began to fear the ability of other banks, who are their counter-parties, to make good on their obligations they demanded higher rates especially from banks already facing liquidity problems which only compounded their original the situation.

A rapid rise in a country’s interbank lending market is also a good predictor of the direction of a country’s currency, or at worst a confirming indicator. Let’s have a look at the interbank lending market of a few emerging nations over the last 12-18 months and then look at what is happening with the renminbi. I think it is instructive for what we have been positioning for in our funds."

In truth, it was an easy bet to make.

Volatility was around 2%! NOT buying put options would have been like having Scarlett Johansson invite you into her bed and then falling promptly asleep. You just couldn"t do that. And so you had to buy.

Taking a look at the Chinese interbank lending today:

Not yet getting critical but worth watching.

And pricing of the options:

So a 6.6% move to make 100%. Seems reasonable but nowhere near as good as it looked in late 2014 - unfortunately.

The problem - if there is one - is that 12 months is a long time to date an ugly girl, work for a nasty boss, or drive a Lada. But it isn"t a particularly long timeframe to hold an option for.

And yet that"s the best the option market gives us.

Sure, you can throw your towel into the ring in the futures markets but if, like me, you dislike leverage and margin calls (because you WILL get it wrong at some point), then you"re going to have to figure some better way to ride this pony.

The answer, I think, is this.

- Chris

"What you see when the liquidity dries up is people start going down... and this is the beginning of the Chinese credit crisis." — Kyle Bass

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China 'Shadow Banks' Crushed As Liquidity Costs Hit Record High

During the so-called Chinese Banking Liquidity Crisis of 2013, the relative cost of funds for non-bank institutions spiked to 100bps. So, the fact that the "shadow banking" liquidity premium has exploded to almost 250 points - by far a record - in the last few days should indicate just how stressed Chinese money markets are.

While interbank borrowing rates have climbed across the board, the surge has been unusually steep for non-bank institutions, including securities companies and investment firms. They’re now paying what amounts to a record premium for short-term funds relative to large Chinese banks, according to data compiled by Bloomberg.

The premium is reflected in the gap between China’s seven-day repurchase rate fixing and the weighted average rate, which, by Bloomberg notes, widened to as much as 2.47 percentage points on Wednesday after some small lenders were said to miss payments in the interbank market. Non-bank borrowers tend to have a greater influence on the fixing, while large banks have more sway over the weighted average.

"It’s more expensive and difficult for non-bank financial institutions to get funding in the market," said Becky Liu, Hong Kong-based head of China macro strategy at Standard Chartered Plc. “Bigger lenders who have access to regulatory funding are not lending much of the money out.”

Without access to deposits or central bank liquidity facilities, many of China’s non-bank institutions must rely on volatile money markets. As Bloomberg points out, The People’s Bank of China has been guiding those rates higher in recent months to encourage a reduction of leverage, while also stepping in at times to prevent a liquidity crunch.

The PBOC responded to this week’s jump in borrowing costs by making an unscheduled injection of hundreds of billions of yuan on Tuesday, and it followed that with another addition of cash through daily open-market operations on Wednesday.

"The PBOC is allowing smaller lenders to miss payments in order to force financial institutions to de-leverage," said Harrison Hu, chief greater China economist at Royal Bank of Scotland Group Plc in Singapore.

"But it will keep a fine balance. It doesn’t want the pressures to become out of control. There’s a possibility that the PBOC will directly inject funds in smaller banks, if the cash shortage continues.”

As Goldman noted, the rate surge reflects a combination of:

• A tightening bias by the PBOC. The central bank has shifted policy stance since autumn last year, but the clearer interbank rate rise in recent days suggests that the hawkish bias has stepped up further.


• Diminished clarity of the role of interbank rates in the PBOC’s policy framework. Since mid-2015, interbank rates had been kept largely steady, partly reflecting the PBOC’s efforts to build up a policy rate framework centering on interbank rates. The PBOC has also introduced SLF (standing lending facility), which is understood as a tool to keep volatility in interbank funding conditions low. However, in a signal that deviates from these previous efforts, the PBOC last Thursday tried to dissociate interbank rates from “policy rates”, which the PBOC said should mean benchmark bank lending and deposits rates. The comment appeared to open up a bigger scope for the PBOC to allow interbank rates to move higher (with the possible intention to avoid conflict with its official “stable and neutral” policy stance or potential pushback from other policy authorities).


• The SLF mechanism appears to have not functioned effectively in recent days. There have been occasional breaches of the general 7-day repo rate above the SLF rate (3.35% per PBOC’s official communication, although it was reportedly raised to 3.45% last week). This suggests that SLF has not effectively fulfilled its supposed function of imposing a ceiling to interbank rates. One possible reason is that SLF is accessible only by banks, and much of the spikes of the general 7-day repo rate have been a result of liquidity scramble by NBFIs (which have no SLF access), while banks" interbank funding cost (as measured by DR007; Exhibit 1) has remained more moderate and still below the SLF rate (note that the 7-day repo fixing rate is partly based on funding cost of NBFIs as well). Nevertheless, the apparent lack of effectiveness of SLF in suppressing interbank rate volatility might have weakened the anchoring of the market’s rate expectations in the near term, and such uncertainty could have compounded the liquidity squeeze.


• Continued high interbank repo borrowing by funds. The wide gap of R007-DR007 reflects continued stress imposed by NBFIs, likely particularly funds, on the funding market. Indeed, as of end-Feb, interbank repo borrowing by funds remained high at over 30% of the interbank repo borrowing (Exhibit 2) despite the increased pressure on the commercial viability of repo trades (borrowing via interbank repo to finance long-dated bond holdings).


• Regulatory impact. The PBOC has tightened the prudential requirements (particularly on the growth of banks" balance sheet) under its MPA examination, which is to be conducted at quarter-end. This has likely further contributed to, and amplified the impact of, a tightening in the interbank market.

In total, the interbank rate volatility may remain quite high in the coming days, especially in light of the near-term consideration of MPA examination at quarter-end and the PBOC"s apparent deviation from the previous monetary policy framework. Alternatively, today"s plunge in the dollar may have had a secondary purpose of easing Chinese financial conditions, where the ongoing dollar rally has pushed the local financial sector to the brink of illiquid collapse.

Libor Spikes Most In 15 Months To 8 Year Highs

The cost of funding for your average joe, average corporation, and average swaps trader, surged overnight. 3M Libor rose by the most since Dec 2015 (Fed rate hike) to the highest level since April 2009.

Biggest jump since the fed rate hike in Dec 2015...

As Reuters reports, the cost for banks to borrow funds in U.S. dollars surged by the most since December 2015 on Wednesday, a day after a series of Federal Reserve officials jolted short-term interest rate markets with talk of a near-term rate rise.

U.S. 3-month Libor was set near an eight-year high early on Wednesday at 1.09278 percent compared with 1.064 percent on Tuesday. The 2.878 basis point rise was the largest since Dec 17, 2015, the day after the Fed"s first rate hike following the financial crisis and the Great Recession.

The jump comes as short-term rate markets are rapidly repricing the risk that the U.S. central bank may deliver another rate increase as early as mid-March, when its monetary policy committee next meets.

In recent days a clutch of Fed policymakers have spoken about the case for a near-term rate hike becoming more compelling in the aftermath of the election of Donald Trump as president and a Republican-controlled Congress intent on pursuing an aggressive pro-growth economic agenda.

The latest voices to argue that case came on Tuesday, when both the influential heads of the New York and San Francisco Federal Reserve banks signaled they are concerned about waiting too long to press rates higher.

Driving up the cost of funding to 8 year highs...

Still when did a rising cost of funds ever hurt an economy? Oh wait.

The last time 3M Libor was at this level, The Dow was half its current price...

Chinese Interbank Lending Freezes; Government Bond Trading Halted After Massive PBOC Liquidity Drain

Earlier today, we were surprised to note that having aggressively drained liquidity from the interbank funding market, on the first trading day of 2017, the PBOC not only fixed the Yuan well lower (sy 6.9498 vs 6.9370 on the last day of 2016, even if this was well stronger than the Offshore Yuan), but the People"s Bank of China withdrew even more liquidity. It did that by injecting CNY20 billion via 7-day reverse repos and another CNY20 billion via 14-day reverse repos in its open-market operations Tuesday, according to traders, while continuing to skip 28-day reverse repos.

The move resulted in a net drain of CNY155 billion for the day, and followed a substantial drain of a net CNY245 billion last week - the first removal of liquidity in three weeks. We promptly followed up with a warning:

PBOC drains a net CNY155 billion for the day. Keep an eye on overnight SHIBOR/ HIBOR/ Repo

— zerohedge (@zerohedge) January 3, 2017

Just over an hour later, it appears our warning was warranted, because according to the latest daily fixing of the Treasury Market Association, as a result of the PBOC"s massive liquidity drain which soaked up a nearly a third of a trillion Yuan in the past two weeks, the interbank market is freezing again as follows:

• 1-month yuan interbank rate in Hong Kong rises 1.16ppts to 13.01%,


• 3-month CNH Hibor +89bps to 10.02%;

Most importantly, the overnight CNH Hibor rate soared 4.95% to 17.76%, the highest since September, andconfirming of yet another daily freeze in interbank lending simply so that the PBOC can punish all those who are still short the Yuan. 

The good news: at least the UCDCNH tumbled by as much as 200 pips on the session. The bad news, it is unclear how much more of this daily volatile punishment Chinese and Hong Kong banks can take.

But wait, because the interbank freeze was not all, and in a repeat of two weeks ago when China"s halted the trading of its government bond future, the Shanghai Stock Exchange announced that Shanghai halted trading of the 3.99% government bond due May 2065 after "abnormal fluctuations."  It was not exactly clear what that particular phrase meant aside from "aggressive selling" as per the chart below.

According to a statement, trading was set to resume at 11:06 am after being halted at 10:36am, but not before the exchange called on investors to "remain rational and reminded them of trading risks." In other words, please don"t sell, especially when the central bank just yanked a near record amount of liquidity from the market.

Chinese Interbank Funding Freezes Again As Overnight Repo Hits 33%

While we have previously shown the amazing gimmicks the Chinese central bank does with the short end of the offshore Yuan interbank offered rate, which as previously explained, and as shown in the animation below, has become the PBOC"s favorite means of punishing currency speculators by making Yuan borrowing costs against shorts crushingly high, forcing short unwinds...

... when it comes to more traditional unsecured short-term funding markets, like the simple overnight repo, these reflect overall levels of liquidity in the interbank market, or as the case may be, complete absence thereof.

And while China is notorious for suffering major liquidity shortages heading into a new year (including the non-lunar variety), what happened overnight in China is worth pointing out because according to Bloomberg data, the overnight repo rate traded on Shanghai Stock Exchange soared as much as 30.87% to 33%, the highest since September 29, before closing at 18.55%.

And while some of the liquidity squeeze was certainly calendar driven, what is more concerning for Chinese markets, where as we reported recently the local authorities, regulators and even press are confirming that the government crackdown on the credit and housing bubble may be serious for once due to fears about "rising social tensions", much of the overnight repo rate spike was driven by the PBOC which pulled a net 150 billion yuan of funds in open-market operations today, the most since December 7.

The result was another brief, but painful, freeze of the interbank lending market.

Should the PBOC continue to not only not inject liquidity among banks, but aggressively withdraw it, it is possible that a repeat of the 2013 bank crisis when as a result of the government"s eagerness to delever the economy it almost crushed its financial sector (it ultimately gave up, with Chinese debt/GDP subsequently rising to 300% according to the IIF), should be one of the more notable risk factors for 2017.

Chinese Interbank Lending Freezes, Forcing Massive Intervention By China's Central Bank

China is finding itself in an increasingly more untenable situation, trapped on one hand by its sliding currency (and declining reserves), which as noted earlier it has manipulated higher by forcing overnight unsecured rates to spike, in the process punishing  "speculators" and other shorts...

 

... and on the other, by a banking sector that finds itself desperately in need of liquidity, unable to endure the PBOC"s monetary interventions, and on the verge of a liquidity crisis comparable to what Chinese banks suffered in the summer of 2013 when overnight rates briefly shot up above 20% as China pushed aggressively with a failed deleveraging campaign.

All this came to a head late last week when as Caixin reported late on Thursday, interbank lending froze on Thursday after many commercial banks suspended interbank operations amid tight liquidity conditions. Caixin adds that major institutions such as securities firms and fund managers, suddenly found themselves in a liquidity vacuum after banks, including the big four state-owned banks, became reluctant to make loans.

The magazine added that liquidity had become a major factor affecting the market after the central bank increased the cost of capital through open market operations in the past month, something we highlights three weeks ago in "The Market"s Next Headache: China"s (Not So) Stealth Tightening."

The latest liquidity freeze forced China"s central bank to immediately extend hundreds of billions of yuan in emergency loans to financial firms on Friday and "ordered" some of the country’s biggest lenders to extend credit as well, as it moved to ease a liquidity crunch and continuing debt selloff. 

On Friday, the PBOC tapped an emergency lending facility it created in 2014 to extend 394 billion yuan ($56.7 billion) in six-month and one-year loans to 19 banks. That pushes the net amount extended through the facility to 721.5 billion yuan so far in December, a monthly record, according to Beijing-based research firm NSBO.  The central bank also injected a net 45 billion yuan into the money market on Friday, following a net 145 billion yuan cash infusion on Thursday.

The PBOC also ordered a few large banks to extend longer-term loans to nonbank financial institutions, while China’s securities regulator asked brokers tasked with making a market in bonds to continue trading and not shut any companies out of the market, according to Mr. Zheng of Dongxing Securities.

“The whole market is scrambling for liquidity and the PBOC is ready to do more to calm the market,” said Arthur Lau, head of Asia ex-Japan fixed income at PineBridge Investments in Hong Kong.

According to the WSJ, Investors and analysts said that the PBOC’s moves—which ended up pumping around 600 billion yuan ($86.3 billion) into the markets and financial system in two days—have helped calm some of the jitters.

“These policy interventions have helped tremendously in pacifying the mood,” said Zheng Lianghai, fixed-income analyst at Dongxing Securities in Shanghai.

It is unclear if the "pacified mood" will last: as a reminder, last Thursday, China briefly halted trading in bond futures after a record bond market crash send China"s 10Y yield plunging by the most on record, wiping out over a year of gains.

One day later, China suffered its first failed Bill auction since introducing a Primary Dealer system, which theoretically should have made "failed auctions" a thing of the past, over investor concerns of spiking short-term rates.  On Friday, the yield on China’s 10-year government bond jumped about 0.1 percentage point to 3.33%, while yields on the interest-rate sensitive two-year government bond and the 30-year bond, which responds to inflation expectations, rose even more.

According to the WSJ, year-end factors are exacerbating liquidity concerns, among them banks storing up cash to prepare for an expected rush to move money abroad in the new year, when Chinese foreign-exchange quotas for individuals reset. Banks are also preparing for an early Lunar New Year in 2017, when Chinese traditionally give gifts of cash.

Yet some market-watchers say that a host of factors—from rising global rates to the central bank’s attempts to deflate China’s asset bubbles—could hit the country’s $9 trillion bond market, where yields hit record lows this year. If the bond selloff accelerates, some analysts fear China could see a market crash like the one that hit stocks last year.

Indeed, the jitters go deeper than seasonal factors. Increased prospects for inflation—and a more hawkish Fed—come as Chinese regulators have already started to tighten short-term borrowing conditions in recent weeks to cool overheating Chinese markets. Over the past year, speculators have borrowed from money markets to fund investments in bonds and other financial products.

So while the PBOC can easily pump liquidity, it could come at the expense of further devaluation in the Yuan, which last week saw its lowest print on record, just shy of the key 7.00 level. A weakening Chinese currency, which has fallen 7.2% against the U.S. dollar this year, has also kept the pressure on officials to tighten monetary policy and stem capital outflows, however it is these same tight conditions that have led to the banking freeze, putting the PBOC in a quandary: does it focus on the banks, or the Yuan.

Meanwhile, the country’s foreign-exchange reserves plummeted by $69 billion in November to $3.052 trillion, putting reserves at their lowest level since March 2011. Officials are ramping up their capital controls to keep the yuan from fleeing overseas by cracking down on overseas acquisitions by mainland companies and limiting how much money multinational companies can move out of the country and into their global operations.

As the following table lays out, while China still has a substantial liquidity buffer left, a worst case scenario could see China running out of liquid US holdings in just around 15 months.

Chinese banks are also being pushed by new domestic regulations to bolster capital levels, and some are rushing to boost their cash positions by selling bonds before the year-end deadline, analysts say.

Further complicating matters, was the announcement by a top economic official on Saturday that China must do more to deflate a property bubble that expanded this year by "strictly" controlling speculation while also stepping up the fight to rein in excessive corporate borrowing, suggesting further monetary tightening is on deck.

"We need to give a higher priority to preventing and controlling financial risks," Yang Weimin, deputy director of the Office of the Central Leading Group on Finance and Economic Affairs, said Saturday at a forum in Beijing. "We need to defuse a flurry of risks, contain asset bubbles, and improve oversight to ensure there won’t be a systemic financial risk."

Yang spoke a day after China’s top policy makers said they plan prudent and neutral monetary policy next year to sustain a steady expansion with breathing room for reforms. Preventing and controlling financial risk to avoid asset bubbles will be a priority, officials said in a statement Friday after the three-day Central Economic Work Conference.

"Houses are built to be inhabited, not for speculation," the post-meeting statement said. It proposed using finance, land, taxation, investment and other instruments "to establish a fundamental and long-term system to curb real-estate bubbles and market volatilities," according to a report Saturday from the official Xinhua News Agency. Yang, who helped draft Friday’s statement, sits on the Communist Party’s elite financial and economic panel led by Xi that is shaping policies to help support growth. The director of the panel’s general office is Liu He, one of Xi’s top advisers which likely means that China"s top priority at this point will be withdrawing further excess liquidity from the market in a gradual attempt to restore affordability to China"s housing market.

The question is whether China can do that while avoiding a hard landing for the banking sector, which once again finds itself desperate for liquidity, yet while can also ill afford further capital outflows, which would result from additional liquidity injections by the central bank. 

As stated earlier, this suggests that the PBOC will soon have to make an unpleasant choice: deflate the housing bubble, and avoid an acceleration in capital outflows, or preserve the viability of China"s creaking banking sector and continue with massive "emergency" liquidity injections.