Fed Says Dealers Tighten Terms on Hedge-Fund Security Trades

December 29, 2011, 11:22 PM EST By Scott Lanman and Matthew Leising

(Updates with interest-rate swap spread in seventh paragraph.)

Dec. 29 (Bloomberg) -- Wall Street dealers made it tougher for hedge funds to finance trading of securities and derivatives in the three months through November, a Federal Reserve survey showed today.

Responses “indicated a broad but moderate tightening of credit terms applicable to important classes of counterparties,” especially hedge-fund clients, trading real estate investment trusts and nonfinancial corporations, according to the quarterly survey of senior credit officers at 20 dealers covering the period of September to November. The central bank released the report in Washington.

The report adds to evidence of stress in the financial system from Europe’s sovereign-debt crisis. Investor concern about the continent’s turmoil has helped drive the premium banks pay to borrow dollars to the highest in more than two years. The Fed survey didn’t discuss causes of the tighter financing terms.

Respondents reporting tougher borrowing terms for hedge funds “most frequently pointed to a worsening in general market liquidity and functioning and to reduced willingness to take on risk and, to a lesser extent, adoption of more-stringent market conventions and deterioration in the strength of counterparties as the reasons,” the Fed said.

Credit Limits

The Fed’s Senior Credit Officer Opinion Survey on Dealer Financing Terms was conducted from Nov. 15 to Nov. 28. Respondents, who aren’t identified, “account for almost all of the dealer financing of dollar-denominated securities for nondealers and are the most active intermediaries” in over-the- counter derivatives markets, the Fed said.

Measures of stress in credit markets soared during the three-month period surveyed to the worst levels in more than two years as Europe’s fiscal imbalances intensified, fueling concern that the region’s upheaval would taint bank balance sheets globally,

The U.S. 2-year swap spread rose 40 percent in the three- month period to 41.55 basis points as of Nov. 30 after peaking at 59.25 on Nov. 22, according to data compiled by Bloomberg. The difference between the two-year swap rate and the comparable-maturity U.S. Treasury note yield expanded to 48.63 basis points today.

Another signal of weakness in the banking system, the spread between the three-month London interbank offered rate, or Libor, and the overnight index swap rate, has more than doubled in four months to 0.49 percentage point today. That’s the widest since May 2009, as financial markets were still recovering from the collapse of Lehman Brothers Holdings Inc.

Interbank Lending Divergence

While the Fed said today that 80 percent of dealers reported lowering credit limits for some specific financial- institution counterparties, evidence grew that banks were growing more wary of lending to each other.

The gap between the highest and the lowest rates that banks say they can borrow from each other in dollars is close to a 2.5-year high.

The divergence from reported fixings by the 18 banks contributing to the three-month London interbank offered rate reached 28 basis points today, within two basis points of the widest since May 2009. Libor for three-month loans climbed to 0.581 percent, the most since July 2009, even as central banks injected cash into the market.

U.S. economic data released today may point to some easing of terms for bank customers as the world’s largest economy improves. Companies cranked out more goods in December and pending sales of existing homes jumped in November for a second month.

‘Signs of Life’

The Institute for Supply Management-Chicago Inc. said its business barometer was little changed at 62.5 from a seven-month high of 62.6 in November. The index of signed contracts to buy previously owned houses rose 7.3 percent after climbing 10.4 percent the prior month, the National Association of Realtors said. Both figures surpassed the median estimate of economists surveyed by Bloomberg News.

“2011 is ending on a solid note,” said Ryan Sweet, a senior economist at Moody’s Analytics Inc. in West Chester, Pennsylvania, who forecast a reading of 63 for the Chicago index. “Manufacturing has some momentum,” he said, and “we’re starting to see some signs of life in housing.”

Combined with a drop in firings over the past month and improving consumer confidence, the data show the world’s largest economy may be strengthening enough to fend off major damage from the European debt crisis. Stocks rallied, buoyed by the stronger-than-projected readings and by a decline in Italian borrowing costs and a benchmark gauge of U.S. company credit risk dropped to a three-week low.

Corporate Credit Risk

The Markit CDX North America Investment Grade Index of credit-default swaps, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 2 basis points to a mid-price of 119.9 basis points at 4:52 p.m. in New York, according to data provider Markit Group Ltd.

The swaps index, which typically falls as investor confidence improves and rises as it deteriorates, has declined from 127.8 on Nov. 30. It rose from 114.5 at the end of August to 150.1 on Oct. 3, the highest level since May 2009.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The Standard & Poor’s 500 Index climbed 1 percent to 1,263.02 at 4:33 p.m. in New York. The yield on the benchmark 10-year Treasury note fell two basis points, or 0.02 percentage point, to 1.9 percent, according to Bloomberg Bond Trader prices.

Dealer Report

The Federal Reserve began querying dealers in 2010 as part of efforts to boost surveillance of financial markets following the panic of 2007-2008 that caused the worst economic downturn since the Great Depression.

The prior survey, covering June through August, showed that 86 percent of respondents reported that the number of dealers tightening financing rates outnumbered those easing.

The latest responses “reflect an apparent continuation and intensification of developments already in evidence in the September survey,” the Fed said today. About one-third of respondents tightened pricing terms, such as financing rates, to hedge funds, while one-fourth reported tightening nonprice terms including maximum maturity, the central bank said.

Hedge Fund Leverage

At the same time, more than half of dealers “indicated that hedge funds’ use of financial leverage, considering the entire range of transactions with such clients, had decreased somewhat over the past three months,” the Fed said.

The Fed survey also found that liquidity and functioning were little changed in the U.S. Treasury securities market since the second quarter, while one-fifth of respondents said equity- market functioning had “deteriorated somewhat.”

The European Central Bank’s balance sheet ballooned this month to a record 2.73 trillion euros ($3.53 trillion) on a surge in loans to financial institutions. The ECB last week awarded 523 banks three-year loans totaling 489 billion euros to encourage lending to companies and households and prevent a credit shortage.

The Fed’s balance sheet has also increased this month to a record, reaching $2.92 trillion last week, on dollar loans to European banks through currency-swap lines.

The ECB this month cut its benchmark interest rate to 1 percent, matching a record low, as the debt crisis threatened to engulf Italy and Spain, the euro area’s third- and fourth- largest economies. The Fed has been considering further measures to ease U.S. borrowing costs and protect the economy from the European turmoil.

--With assistance from Bob Willis in Washington and Anchalee Worrachate in London. Editors: Pierre Paulden, Alan Goldstein

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Matthew Leising in New York at mleising@bloomberg.net

To contact the editors responsible for this story: Carlos Torres at ctorres2@bloomberg.net; Alan Goldstein at agoldstein5@bloomberg.net

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No Love Lost for U.S. Debt as Dealers Sell Fewer Bonds to Fed

May 31, 2011, 12:17 AM EDT By Cordell Eddings and Liz Capo McCormick

(Updates with today’s 10-year yield in eighth paragraph.)

May 31 (Bloomberg) -- The world’s biggest bond dealers are finding fewer Treasuries to sell to the Federal Reserve as its $600 billion purchase program nears an end, a signal of rising demand even as the largest buyer steps away.

The two-week moving average of bond dealers’ submissions for sales to the Fed has fallen 37 percent to $17 billion a day from the $27.3 billion peak offered in November, according to Bloomberg data. Price swings have diminished to levels last seen before the financial crisis began in 2007, helping bonds outperform stocks this month by the most since July.

Demand for government debt is increasing even as the central bank prepares to conclude its purchases, the size of the market has doubled to $9.1 trillion and Republicans in Congress spar with President Barack Obama over the nation’s debt ceiling. By offering fewer bonds to the Fed, dealers are signaling that any rise in yields after the end of so-called quantitative easing will be limited and that Obama faces no impediment to funding the $1.5 trillion budget deficit.

“The Fed’s QE2 program finally appears to be exhausting the supply of Treasuries that can easily come out of investor portfolios, a bullish sign for the market,” said Terry Belton, the global head of fixed-income and foreign-exchange research at JPMorgan Chase & Co., one of the 20 primary dealers who trade debt with the central bank.

Submissions Drop

The Fed began the second round of asset purchases, known as QE2, on Nov. 10 after buying $1.7 trillion in securities through last year, increasing the amount of money in circulation to prevent deflation. The Fed’s purchases are due to end next month. Dealers have submitted more than $2.4 trillion in Treasuries to the Fed over the past six months.

While QE2 succeeded in avoiding deflation, investors remain concerned about the strength of the economy, which grew at a 1.8 percent annual pace in the first quarter, the slowest rate since the three months ended June 30.

U.S. government securities have returned 1.4 percent in May, including reinvested interest, following a 1.15 percent gain in April, Bank of America Merrill Lynch data show. The Standard & Poor’s 500 Index fell 2.4 percent this month and the Standard & Poor’s GSCI commodity index lost 7.9 percent.

Bonds rose last week, driving the yield on the benchmark 10-year note to as low as 3.05 percent, the least since Dec. 7. The price of the security due in May 2021 increased 19/32, or $5.94 per $1,000 face amount to 100 13/32. Ten-year yields fell seven basis points to 3.07 percent, according to Bloomberg Bond Trader prices. The rate was 3.08 percent today as of 12:31 p.m. in Tokyo.

When Yields Rise

Investors should buy Treasuries when yields rise, because the U.S. will grow an average of two percent to three percent for the next few years, said Rick Rieder, chief investment officer of fixed income at New York-based BlackRock Inc., the world’s largest money manager, overseeing $3.45 trillion.

“There is a need for fixed income given the atmosphere,” Rieder said. “Yields are at the low end of the range, but Treasury rates could stay in this low range for years as the economy grinds along.”

Yields on 10-year notes plunged from the high this year of 3.77 percent on Feb. 9 on signs that rising energy and food costs will restrain the recovery from the worst financial crisis since the Great Depression.

The decline should end at 3 percent as U.S. employment improves and QE2 ends, according to William Cunningham, the co- head of global active fixed income in Boston at State Street Global Advisors, which oversees $2.1 trillion.

Higher Rates

Payrolls expanded by 244,000 in April, the biggest gain since May 2010, after a revised 221,000 increase the prior month, the Labor Department said May 6. Employment rose by 185,000 jobs in May, according to a Bloomberg survey of economists before the June 3 report.

“If the employment picture keeps chugging along as it is, then it will drag rates higher,” Cunningham said in an interview in New York on May 25. “Yields will gradually go up this year.”

Cunningham expects the 10-year yield to end the year in the 3.5 percent to 3.75 percent range.

Demand for Treasuries has been boosted as regulators try to strengthen the global banking system by requiring financial institutions reduce risks and hold more of the safest assets after about $2.01 trillion in writedowns and losses since the start of 2007. Banks owned a record $1.69 trillion of U.S. government-related debt in the week ended May 4, Fed data show.

Repo Rates

Treasuries are in such short supply in the $4.9 trillion-a- day repurchase agreement market used by dealers to finance their holdings that investors are lending cash for next to nothing to obtain the bonds. The average level of overnight general collateral repo rates fell as low as 0.01 percent on May 5. About a third of government securities transactions in the repo market trade below zero percent, according to Barclays Plc data.

Repo rates may move further below the Federal funds rate when the central bank begins lifting borrowing costs. The Fed’s so-called effective rate, a weighted average of trades between major brokers, was 0.09 percent on May 26.

“Everybody wants more collateral and Treasuries are the best collateral in the world,” according to Stanford University professor Darrell Duffie, who serves as a member of the Federal Reserve Bank of New York’s financial advisory roundtable.

“You’d think that the world would be awash in Treasuries as the U.S. is issuing more than they ever have,” said Duffie, who studies credit risk, asset pricing and the over-the-counter derivatives as the Stanford Graduate School of Business’s Dean Witter Distinguished Professor of Finance. “But everybody wants them.”

Debt Ceiling

A congressional standoff on raising the country’s debt ceiling has increased demand for bills. Government authorities have curtailed short-term debt sales to conserve borrowing capacity and avoid breaching the Congressionally-mandated threshold of $14.3 trillion.

The reduction has left U.S. six-month bill rates hovering near record lows of 0.005 percent.

Senate Republican leader Mitch McConnell of Kentucky has said his party wants “significant” cuts in spending and no tax increases as a condition for raising the limit. House Speaker John Boehner, a Republican from Ohio, said Congress needs to pair an increase with spending cuts and changes to the nation’s “broken” budget process.

“At some point it’s clear to me that we have to increase the debt ceiling,” Boehner, an Ohio Republican, said May 15 on CBS’s “Face the Nation.” “And as we do, we’re going to do it in a way that addresses America’s long-term fiscal challenges.”

Auction Demand

Obama said in a segment for the show taped May 11 in Washington that failing to raise the ceiling may disrupt the global financial system. Treasury Secretary Timothy F. Geithner said he has taken steps to prevent a federal default until Aug. 2, using accounting measures that involve two retirement funds.

So far, there’s been no sign of waning demand for government debt that increased by about 50 percent as Obama boosted spending to pull the economy out of the recession that probably ended in the third quarter of 2009. The Treasury has received $3 in bids for every dollar auctioned this year, up from last year’s record $2.99, Treasury data show. The U.S. has sold $895 billion of notes and bonds this year, compared with $1.003 trillion at this time in 2010.

Treasuries have become more desirable as price swings declined. The Merrill Option Volatility Estimate, or MOVE, index fell to 74.80 basis points on April 25, within 0.7 of its lowest level since July 2007. The index is down from a 12-month high of 125.2 on Dec. 15.

Biggest Buyer

The Fed is responsible for some of the decline. QE2 made it the biggest owner of U.S. government debt, with holdings of $896.7 billion overtaking China’s $895.6 billion in November, according to Treasury and central bank data.

Under the program, the central bank has purchased $675 billion since Nov. 12, mostly from dealers. Fed Chairman Ben S. Bernanke has said he’ll maintain record stimulus until job growth accelerates and the recovery is robust enough to withstand tighter credit.

Inflation is barely eroding the value of fixed-income securities as the recovery slows. The Fed’s preferred measure of price increases, the so-called core inflation reading that excludes food and energy, was 1 percent for the 12 months ended April, the Commerce Department said on May 27.

The Washington-based International Monetary Fund lowered its forecast for U.S. growth this year, predicting the economy will expand 2.8 percent this year, down from the 3 percent projected in January.

“Yields are going to remain around these levels in a range for some time,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion in assets. “The market is running with the slow growth story right now.”

--With assistance from Daniel Kruger and John Detrixhe in New York and Wes Goodman in Singapore. Editors: Philip Revzin, Dave Liedtka

To contact the reporters on this story: Cordell Eddings in New York at ceddings@bloomberg.net; Liz McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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