Ukraine Lehman moment builds around commodities

This is some monetary egghead stuff but it is very important. TD Securities:

US Funding Stress: Ripples in the Water

•Bank unsecured funding levels have risen amid the financial reverberations of the Ukraine invasion. CP-OIS, Libor-OIS, and cross-currency basis have all widened. However, we argue that this is more a function of markets pricing in the potential of significant credit losses in the banking system. Higher credit risk premiums should also widen CP-OIS.

•We don’t see signs of dealer balance sheet constraints, which may be symptomatic of lower leverage in the system. Repo rates are well-behaved and dealer inventories are not high. This could change if credit continues to deteriorate, but for now, this channel of funding stress is not significant.

•There is a strong correlation between CP and Libor but the recent widening in Libor-OIS has not fully caught up with the move in CP-OIS. This suggests that even if CP spreads stabilize at current levels, Libor settings should continue to move higher. Note that FRA-OIS averaged around 25bp between 2015 and2018 when the Fed was hiking rates. Current levels have now jumped above these more “normal levels” and the pace of the increase is certainly concerning.

•Supply-demand trends in the CP market will be important to track going forward. Foreign CP issuance increased sharply over the past year. Note that prime money fund assets have declined since COVID, so the demand for CP likely came from other sources of short duration cash. CP spreads could be pressured higher if foreign banks continue to rely on CP for funding.

•The widening in CP-OIS spreads hints at USD funding stress amid high uncertainty, but it seems to be more about the cost of funding rather than the availability of funding. In addition, if USD funding pressures continue to increase, there are various central bank backstop facilities available. So far these facilities have not been accessed, but we will continue to monitor their usage. From an economic standpoint, it is cheaper to access the swap line than the private market (using CP or cross currency basis).

Barclays with more:

Precautionary borrowing

We suspect that there are two reasons for the pressure on short-term unsecured bank borrowing rates. First, heightened geopolitical uncertainty together with increased market volatility has encouraged banks to build up their precautionary cash holdings. Having a little extra cash on hand—just in case things should deteriorate—might make sense even if borrowing costs are somewhat higher relative to OIS than they were a couple of weeks ago. After all, it has been many years since there was a full-fledged war in Europe. And it might make sense even if there is plenty of liquidity held on deposit at the Fed.

Typically, banks do not have much control over their short-term funding needs. But, often in periods of funding market stress, they will come into the CP market to borrow funds just to demonstrate to investors that they can do so. In addition to raising some precautionary cash this borrowing is meant as a signal to money fund investors that they have no trouble accessin the funding market.

Second, this precautionary borrowing is bumping up against a timing constraint. As we wrote recently, money market investors are holding back in redeploying cash until the Fed raises interest rates. Not only has this created a pileup of paper that needs to be rolled after the FOMC meeting, but it also means that issuers have to pay more of a premium to sell term paper.

Instead, lenders may only be willing to buy CP with maturities only as far as the next FOMC date.

This effect is compounded if there is some uncertainty about the path of rate hikes. If money market investors feel that there is some, non-zero probability, of a 50bp hike at an upcoming FOMC meeting, they may be even more reluctant to lock in at current term rates.

Other indications

Of course, it does not take much for a precautionary build-up of funding driving rates higher into a darker situation, where rates are rising and banks are struggling to raise funding. For now, there doesn’t appear to be any indication that this is occurring. Although lenders in money markets are considering a bank’s Russian exposures when buying its CP, they do not seem to be turning away from issuers. This is quite a bit different from the sovereign debt crisis in 2011 when money market investors became very selective in which CP they would purchase (Australian, Scandinavian and Canadian banks) and those that they wanted to avoid (French banks). We suspect this accounts for the mild widening in CP rates across individual issuers—of about 15bp in the 3m sector. Obviously if the widening turns into avoidance there could be more room for bank unsecured rates to widen against OIS.

Separately, there are no signs of a flight-to-quality in money markets. In past episodes, nervous investors leave prime funds and shift their balances into gov-only funds. They leave prime funds for fear that some of their investments could be in at-risk CP or wholesale time deposits. Sameday redemptions mean that prime fund balances can plunge sharply and quickly if their (institutional) investors start to worry about the fund’s credit exposures. But prime fund balances have been steady all week (Figure 3).

Finally, we are not seeing any strains in repo markets. SOFR and tri-party rates remain low. The 75th volume quartile of the SOFR distribution has inched up to 6bp since last week. The very slight increase in market repo rates has pulled about $200bn out of the RRP. The RRP is a safe haven for money funds worried about credit risk and funding markets. There has been no use of the standing repo facility and the use of the Fed’s dollar swap lines has been very light at just under $300mm, which is largely unchanged this year (Figure 4).

As a result, while we expect that Libor and BSBY will catch up with CP market rates and the widening to OIS to continue, we do not see signs that this is the start of a funding crisis.

Can anyone really tell the difference between “precautionary borrowing” and “first mover panic”?

Readers will know that I began expecting these kinds of impacts in funding markets after last weekend’s ramped sanctions on Russia, especially those levied against the Bank of Russia. The issue was $500bn of forex reserves held in securities that might need to be liquidated.

Is that triggering this spread widening? Or, is it looming Fed hikes? Depending upon which conclusion we draw can have VERY different outcomes for asset prices.

Scenario one is that this is some kind of contagion from sanctions that may pass quickly if the Fed will have to reactivate its USD swap-lines with other central banks even as it lifts interest rates.

This may have the perverse effect of knocking down DXY even as carry rises. In turn, that’s going pour petrol on the raging commodity bonfire, and the inflation panic will intensify while USD’s flood into global markets triggering a risk rally.

Treasuries could get slaughtered in this environment so equities would be caught between a desire to buy tech on new QE, but value on inflation. This would also send the AUD bananas.

Scenario two is that spreads are widening as an early indicator of credit stress from imminent Fed tightening, and will intensify as the rate hikes flow through. Eventually, as it gets out of control, not only will the Fed open its swap lines, but it will also begin QE5 and Treasuries will be a massive buy, the opposite outcome to scenario one.

Then there is scenario three. For that, let’s turn to Credit Suisse and its monetary plumber Zoltan Pozsar:

Yes, we got central banks’ need to step in to calm funding market pressures this week wrong (still no need yet), but we got the direction of spreads right – on February 24thwewarned about an imminent sentiment shift in funding markets. There was no premium last week but there is some funding premium now, and it feels that things can get worse still. So net-net, our call was absolutely right.

Our point with the Lehman analogy last Sunday was to underscore the point that just as the market didn’t realize the complexity and interconnectedness of the financial system then, it may not realize the same today. Again, we are not saying that we are about to have another Lehman moment, only that things can get much worse than you realize. When you rip $500 billion of FX reserves from the system, sanction and de SWIFT banks (which goes live March 12th), and force Western banks and commodity traders to self-police and not trade commodities from the single-largest commodity producer of the world (Russia), unforeseen things can happen and do happen. If you believe that the West can craft sanctions that maximize pain for Russia, while minimizing financial stability risks in the West, you could also believe in unicorns. Yes we were also wrong on Sunday about the trigger of funding pressures – it’s not the Bank of Russia’s inability to roll FX swaps or de-SWIFTing that caused funding pressures to date, but rather the market’s self-imposed unwillingness to buy, move, or finance Russian commodities that’s driving the current massive bid for cash. Bloomberg called the commodities rally “historic,” and so the margin calls must be historic too.

Who is getting the margin calls? Market participants that are long commodities either in the ground or in transit and want to lock in a price by shorting futures. These include every commodity producer in the world including Russia, and every major commodity trading house, respectively. Again, we do not know if this is the case, but it’s reasonable to wonder if Russian commodity producers are experiencing margin calls now, and if they have the resources to pay – could they choose not to pay because their sovereign’s FX reserves were seized? We are not saying they will, but this is a risk one needs to consider. As for the commodity traders, which are suffering a correlated surge in commodity prices (Russia and Ukraine export pretty much everything imaginable), margin calls can be funded by drawing on credit lines from banks, issuing CP, or swapping FX.

One lesson from the March 2020 liquidity crisis was that corporate credit lines (which have a low drawdown assumption according to Basel III) can be drawn across all industries and across all geographies at the same time in a pandemic, and the lesson about the present crisis is that you can have a rally in all sorts of commodities from oil to gas, fertilizers, wheat, palladium, and neon during war, especially if the G7 force the world to self-police and boycott Russian stuff.

Commodities are collateral…

…and every crisis occurs at the intersection of funding and collateral markets. Urals spot trading at a discount to WTI is like subprime CDOs going from AAA to junk. Will all commodities sourced from Russia trade at a significant discount?

Is it possible that the Western boycott of Russian commodities is turning AAA commodities to junk?Does going from AAA to junk trigger margin calls? You bet!

Leverage and liquidity are also important.

In 1998, we had Russian bonds and a leveraged LTCM. In 2008, we had mortgages and leveraged banks and shadow banks. In March 2020, we had leveraged bond basis trades. You see the pattern? Collateral, leverage, funding.

In 1998 and 2008, collateral went bad and a funding crisis hit as a consequence.

In 2020, corporations drew on credit lines, which sucked funding away from leveraged bond RV trades, which then triggered a forced sale of good collateral.

Crises happen either because collateral goes bad or funding is pulled away– that’s been the central lesson in every crisis since 1998. Now on to today…Marc Rich’s legacy in the annals of global finance was to introduce the concept of leverage and borrowed money into commodity trading. It’s simple: a bank lends you the money to lease ships and buy commodities to deliver them sometime and someplace in the future at a locked-in price (via short futures).

Does that ring a bell?

A bond RV fund is long the bond, short the future, and funds the package in the repo market. That’s the same as a commodity trader moving stuff around.

But if collateral spoils, funding is impossible to come by and spot price spikes are triggering margin calls. March 2020 all over again? Probably not the same size, but please be mindful of the parallels and the funding and collateral linkages…

We could be looking at the early stages of a classic liquidity crisis that has elements of both collateral and liquidity problems (1998 and 2008), where some players – commodity traders – are not regulated and have no HQLA, and some players – state-linked commodity producers – are not liquid enough because their backstop – the Bank of Russia’s FX reserves – ha s been seized. I don’t know, but neither do you and that’s worth some funding or risk premium.

Next, a note on sudden stops.

In 1997, we broke some FX pegs because FX reserves we thought were there weren’t, and capital stopped flowing in. In the present context, we clearly are not worried about funding because “o/n RRP is at $1.5 trillion and banks have reserves coming out of their ears”. Fine, we get that. But you should worry about a sudden stop of commodity flows for three potential reasons. First, gas gets turned off “at the top”. Second, there is an accident – lots of pipes run through Ukraine and it’s a war. Third, sabotage in Ukraine to kick-start Nordstream 2.

Please consider: what happens to the gas bit of the commodity derivatives market when there is a sudden stop of physical commodity flows, and what does that do to dealers’ matched books? There is the potential for some exposure there…

Will it happen? We don’t know, but again, the question itself is worth a spread…

In summary, we have bases creeping in and commodities, like collateral in 2008, are becoming bifurcated. Spot prices are staging a historic and correlated surge that is driving demand for cash. And there is leverage in the system both overt and covert – “commodity RV trades” (as an analogue to bond RV trades) and a lack of FX liquidity because of seized FX reserves. Then think about this: Is the reason why we’ve cocooned energy and other commodity flows and related payments and institutions from sanctions to protect the consumer at the pump, or to protect the commodity derivatives ecosystem?

Clearly, the West does not want to turn off the flow of energy, but there are growing risks – more sanctions, more self-policing, and the Russian leadership can act as well.

There is so much more…

There are links between all this and headline inflation and interest rate hikes, and links between the seizure of Russia’s FX reserves and the dollar and demand for long-term Treasuries. We’ll tackle those in Dispatches next week.

Consider this quote from the legendary George Soros:

“Thinking can never quite catch up with reality; reality is always richer than our comprehension. Reality has the power to surprise thinking, and thinking has the powerto create reality.Butwe must remember the unintended consequences – the outcome always differs from expectations”.

This is a quote carved into the wall of the CEU (Central European University) – the Nádor street entrance if you’re in Budapest. Think about that in the present context, and in the context of ABN Amro freezing redemptions from its funds in August of 2007 – a year before Lehman. Did you think it would get that bad?

G-SIBs obviously won’t fail this time around but some other traders might fold, and losses, even if not lethal, can curb balance sheet provision (see Archegos) for all other stuff that the buy side needs – repo, FX, and equity derivatives…

Finally, another quote. This one from a legendary policymaker: Larry Summers. Paraphrasing Professor Summers (based on a speech I heard him deliver in Toronto at an INET event about the lessons learned during the 2008 crisis): crises are not about estimating their economic impact and estimating to the decimal point the GDP impact of a shock. Crises are about fear and greed…

Russia and Ukraine are the single-largest commodity exporters in the world.

Russia, while only 5% of the world’s GDP, is financially deeply interlinked – it used to have $500 billion of FX reserves, and owes about as much in debt to the rest of the world, not to mention “off balance sheet” debt that it owes to the world through derivatives when spot commodity prices rally, like they do now.

It’s a bit more complex to de-SWIFT Russia than it was to de-SWIFT Iran…

To be clear – your correspondent is a funding expert, not a commodity expert, but I see a link between the two markets at the present, and parallels to 2008.

I wasn’t an expert in CDOs in 2007 either, but started to dig the day after Paul McCulley coined the term “shadow banking” at Jackson Hole and I wrote this. My interest was piqued by the legendary Paul McCulley, and current events piqued my interest in the opaque world of the commodity derivatives complex. The books about 1997, 1998, and 2008 have FX pegs, default and leverage, and collateral and leverage as their central themes, respectively.

The books about today’s market events will have commodities as collateral as the central theme.

That’s where we need to dig…

Scenario three is a global commodities-funding margin call that freezes supply. Ironically, this is not an outcome that sees commodity prices rise. As commodity collateral values become worthless, a wholesale puking of long positions to raise cash follows as the global economy grinds to a halt.

At this point, I put the probability of the three scenarios at one-third each.

So far, the spread widening has not infected BBSW in Australia, which may hint that it is scenario one in play given Australia is a relative beneficiary from the sanctions regime. But if either scenario two or three takes hold then Aussie banks are directly in the firing line and the RBA will also be restarting its emergency funding facilities to prevent the crash of house prices before the year is out…

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