Rising Yield Curve Steepens Funding Risk: Market Alert

Rising Yield Curve Steepens Funding Risk: Market Alert 

The growing risk of tightening in US funding markets is becoming more apparent as the yield curve steepens, with long-term yields rising faster than short-term ones. This is driven by several factors, including more attractive yields on short-term bills and increasing interest payments on government debt, which are reducing reserves and their turnover. This situation raises the likelihood of a disorderly surge in funding rates and poses a threat to the stock market.

The bond market, famously described by James Carville as intimidating, is indeed living up to its reputation as yields continue to climb, affecting the entire financial system. Funding risks are resurfacing, potentially leading to a correction in stocks driven by volatility in interest rates.

While concerns about funding issues have been somewhat subdued this year, the current environment is becoming more precarious. The steepening of the yield curve exacerbates the depletion of reserves through declining reverse repo facilities and rising government interest payments.

Recent trends show a bear steepening particularly in the 3-12 month versus 10-year sectors, driven by inflation concerns pushing term premiums higher. This situation is compounded by the declining availability of the reverse repo facility, which has been crucial in supporting risk assets amid a rapid rate-hiking cycle and quantitative tightening (QT).

As the reverse repo facility decreases and approaches zero, it signals a potential decline in total reserves, reaching levels where sudden funding problems become more probable. Recent declines in the facility, influenced by rising short-term bill yields and seasonal factors like tax payments, highlight this downward trend and its increasing volatility.

The rise in longer-term yields, reflecting the bear steepening, adds to the government's interest expenses, which are projected to double soon, reaching significant proportions relative to the national debt. This places further strain on reserves and their turnover, exacerbated by the ongoing QT program.

Contrary to expectations, interest payments to bondholders are unlikely to significantly stimulate domestic spending, as a significant portion is held by financial and foreign sectors with lower propensities to spend domestically. Thus, a bear steepening in the yield curve puts pressure on reserves, their turnover, and their velocity, heightening the risk of a funding crisis.

Past experiences, such as the funding squeeze in September 2019, emphasize the importance of monitoring funding risks closely, especially as indicated by metrics like the Funding Stress Trigger. While current signals may be inactive, a sudden change could lead to increased rate volatility and higher stock-index correlation, potentially triggering a market correction.

Although these risks may not materialize, there are enough preemptive reasons to remain vigilant. The bond market's dynamics, particularly a bear-steepening yield curve, warrant close observation given the current market conditions.

In addition to the concerns about funding, recent market fluctuations, including the Nasdaq's decline and various stress indicators hitting year-to-date highs, indicate rising anxiety among market participants. Liquidity issues, as highlighted by measures like "top of book liquidity" and "cost to sweep liquidity," further compound these worries, especially with upcoming events like earnings season and option expiry.