The Bank of Canada produces a Financial Stability Report to assess the resilience of the domestic financial system and identify risks that could undermine its stability.
One item highlighted in the report is the growth of asset managers’ leverage over the past 12 months, primarily driven by an increase in hedge fund repo activity. These funds take on leverage to enhance potential returns.
The repurchase (repo) market is an obscure but important part of the financial system. Every day this market funds much of the trading activity in the bond market. A repo is a short-term secured loan where one party sells securities to another and agrees to repurchase those securities later at a higher price. The securities serve as collateral, and the difference between the securities’ initial and repurchase price constitutes the interest paid on the loan, known as the repo rate.
Conversely, a reverse repo is the opposite of a repo transaction, where one party purchases securities and agrees to sell them back for a positive return at a future date. Most repos are short term, typically overnight.
Increased hedge fund repo activity is related to two main factors: speculation on future interest rate movements and engaging in cash-futures basis trades. These basis trades involve capitalizing on relative value disparities between different markets – in this case, bonds and bond futures. Traders use leverage to amplify profits from these trades. While these activities contribute liquidity to markets, they can also result in temporary market spikes if there’s a significant unwinding of positions.
This recent activity is not surprising. During a previous period of high inflation in the late 1990s, we witnessed similar activity in the repo market. However, there were differences in market participants and types of trades. At that time, the activity was in outstanding bonds, particularly two-year bonds, as that part of the yield curve was expected to benefit most from declining rates. We saw the 4% bonds of 1999 being squeezed in the repo market. Trading desks could buy bonds, finance the position with repo, and own most of the tradeable supply. Those with long positions in the bond profited from premiums earned in the repo market, as counterparties paid a premium for delivery of bonds in short supply. The situation was eventually resolved when the government increased the supply of these bonds in the market.
Due to changes in capital charges, banks and dealers now hold smaller inventories of bonds compared to 25 years ago. As a result, hedge funds have become more active in their trading. Not surprisingly, there has been an increase in repo activity by hedge funds, particularly in anticipation of potential rate cuts. Similar to previous instances, much of this activity is concentrated in the shorter end of the yield curve.
This increased trading activity has introduced some volatility into the repo market. However, it would take some extreme changes to the market for this activity to become disruptive. For lenders watching the bond market, this is something to be aware of but not a major concern.
Housing Affordability Watch
CMI monitors the latest developments and offers insights on solutions to Canada’s housing affordability crisis
A recent Desjardins report suggests that increased access to 10-year loans could have alleviated some of the current financial stress in the mortgage market. However, while longer-term mortgages could protect borrowers from higher rates at renewal, Desjardins’ analysis fails to consider the potential impacts on the economy. Furthermore, observations from the US market show that despite the prevalence of 30-year mortgages, affordability issues persist. The US housing market faces challenges such as low sales, elevated rates, and rising prices, particularly affecting first-time buyers. While the need for improved mortgage options is evident, it alone cannot solve the affordability crisis. For our full analysis, read the latest Housing Affordability Watch here.
Independent Opinion
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