FAST FIVE: "It's About To Get Very Bad" – Repo Market Legend Predicts Market Crash In Days
The themes pushing G-SIB scores in the wrong direction this year are the equity market rally and the flat curve: (1) the rally in equities is inflating scores through G-SIBs' market capitalization and the value of equities G-SIBs hold as trading assets or available for sale securities; (2) the flat yield curve is inflating scores through G-SIBs' bloated Treasury portfolios, which, given auction supply and the equities rally, may grow further into year-end.
“But these flows will be scraps of excess reserves, not bursts.” As for the worst case scenario, it is one where “collateral upgrades aren't sufficient and US banks stop making markets in FX swaps and so exacerbate the vacuum triggered by foreign banks.” Which brings us to the first of Pozsar's ominous conclusion: “We are on track to realize the worst case scenario, and the market doesn't price for that.” Here, Pozsar offers a brief detour offering some practical observations as we enter the year-end period, in which he notes that “according to our conversations with market participants, US G-SIBs rely heavily on Canadian pensions for equity upgrades to accumulate some excess reserves for the turn.
The BIS's finding was novel, and surprising, as it highlighted the “growing clout of hedge funds in the repo market” echoing notes something we pointed out one year ago: hedge funds such as Millennium, Citadel and Point 72 are not only active in the repo market, they are also the most heavily leveraged multi-strat funds in the world, taking something like $20-$30 billion and levering it up to $200 billion.
We took this detour into how repo affects the hedge fund world, because Pozsar had a rather gloomy prediction about the fate of hedge funds should his dismal forecast materialize.
As he writes, “the relative value (RV) hedge fund community is certain that they will have balance sheet to fund their bond basis trades at reasonable rates over the year-end turn.