What happened to the swap spread? Goldman Sachs warns that the repurchase crisis is resurfacing

The turmoil in the U.S. repurchase market has once again drawn market attention. Looking back at the end of last month, the Federal Reserve's policies led to systemic liquidity tightening in the market, causing repurchase rates to suddenly spike back to levels seen in 2020.

As October comes to a close, the "chaos" in the repurchase market is playing out once again.

Goldman Sachs analyst Vincent Mistretta recently stated in a research report that investors using risk-adjusted (RV/carry) strategies in the market have limited interest in taking on trades with spreads close to those during the pandemic, while leveraged funds are beginning to "moderately reduce risk exposure."

He believes that this situation arises from a combination of several factors, including the Federal Reserve's balance sheet reduction, massive Treasury maturities, election uncertainties, insufficient adjustment capabilities of intermediary institutions, and the Treasury's refinancing plans.

Five Factors Leading to Tension in the Repurchase Market

Mistretta believes that the formation of this tension is due to the interplay of five factors.

First, the Federal Reserve seems willing to continue reducing the size of its balance sheet, despite some obstacles facing the leverage operations of intermediary institutions.

Second, with over $500 billion in Treasury settlements approaching, the market is reluctant to further expose itself to risks in the funding market.

Third, the uncertainty surrounding the upcoming U.S. presidential election has intensified market caution.

Additionally, the adjustment capabilities of intermediary institutions at year-end are also a potential risk point.

Finally, the upcoming Treasury refinancing plan may also exert pressure on the market.

Notably, regarding the second factor mentioned above, on Thursday (October 31), the U.S. Treasury will conduct a record $250 billion in coupons and $281 billion in notes, totaling $531 billion in single-day settlements. Although large single-day settlements are not uncommon at month-end, this scale is still the third-highest net issuance since the end of 2021. The market is unwilling to further expose itself to risks in the funding market.

Goldman Sachs analyst William Marshall previously warned:

"Changes in supply conditions may exacerbate liquidity tightening against the backdrop of banks' waning interest in borrowing from the tri-party system."

Although the risk-adjusted pressure at month-end is relatively lighter compared to quarter-end, Marshall expects that this change will still lead to an increase in short-term financing rates (SOFR) as November begins.

Federal Reserve May Continue Balance Sheet Reduction, Increasing Market Uncertainty

Despite rising market pressures, Mistretta stated not to expect the Federal Reserve to step in at the last moment.

Logan previously emphasized that the Federal Reserve's current assessment of QT and funding pressures suggests that these fluctuations are more friction from intermediary operations rather than signs of liquidity scarcity. She also pointed out that observing the recent usage of the repurchase facility (SRF) may help alleviate some bottlenecks.

Mistretta believes this attitude implies that the Federal Reserve may continue to advance its balance sheet reduction policy until the end of the first quarter of 2025. Given that the market generally holds the same view, Goldman Sachs believes this increases the risk of a severe lock-up in the repurchase market. If a market turmoil similar to that of 2019 occurs, the Federal Reserve may have to intervene early to unfreeze the financial system

Swap Spread Volatility Indicates Potential Risks

The report also pointed out that the continuous narrowing of short-term government bond spreads has raised concerns in the market.

Mistretta reviewed the spread levels during recent similar events:

At the beginning of 2023, the 3-year swap spread fell to -27 basis points, while during the repo crises in 2020 and 2019, the spreads were around -30 and -29 basis points, respectively.

He noted that the current 3-year spread is approximately -25, a level similar to the fluctuations during these extreme events, forcing investors to be more cautious.

Mistretta stated that recently, the market's risk aversion sentiment has increased, with investors primarily reducing risk exposure rather than actively seeking risk.

Combined with the uncertainty of fiscal policy and potential market adjustment pressures, he warned that the market may face greater volatility in the future, especially as the repo market continues to be under pressure