For most of the last 15 years, collateral was scarce. As the financial system shifted towards collateralised funding, demand for safe assets grew. But there is a limit. The amount of issuance now causes central bankers to worry about the effect on short rates. Both Fed and ECB members indicate this may require central banks to maintain ‘abundant’ reserves, historically large balance sheets and despite this, perhaps not eliminate the risk of upward pressure on short-end rates.
The contraditions are getting more airplay. The Bank of England hosted a conference in late February on ‘The Future of the Central Bank Balance Sheet’. The combined information supplied seems pointed in one direction – the size of central bank balance sheets will remain high in advanced economies, relative to GDP. There were fascinating divergence between speakers. And implicit warnings about funding for ‘shadow banks’.
A number of contributions are worth reading in detail, but you may not want to wade through the technical stuff, so I’ll try to distill some key messages, and differences of opinion. Bottom line, central banks on both sides of the Atlantic recognise the limits to balance sheet reduction, and the upward pressure placed on short-term rates by an abundance of collateral due to continued fiscal deficits. Government bond issuance is likely to remain high and may increase, given the defence and social needs of the US and Europe. Short rates are required, by the configuration of the plumbing, to respond to over-supply of collateral with upward pressure on repo. As almost every transaction is now collateralised, the cost of finance will biased higher.
Either explicitly or implicitly, the Trump administration appears to recognise this. But geopolitical pressures are likely to keep the government demand for funding growing, meaning over-supply of collateral may risk spikes in funding costs – especially at quarter-end. The market appears to have taken note, probably because of repo spikes at end-2024. Cash/futures basis has reduced exposures through Q1 2025, so perhaps end-March will avoid a repeat move. But asset managers (as distinct from hedge funds) show little sign of switching away from their preference for derivative positions over cash Treasuries, meaning continued enticement on the cash/futures basis. There has been some adjustment by dealers to fill the gap, but their appetite is limited. Meaning in turn, upward pressure from issuance (increased collateral) will continue to threaten upward pressure on both bond yields and intermittently on repo rates for the foreseeable future.
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