Repo crisis becomes machiavellian opportunity for some investors

“Never waste the opportunity offered by a good crisis,” is a quote first attributed to the Italian Renaissance writer Niccolo Machiavelli and repeated by politicians the world over ever since.

It also became a main theme for fund managers this week as chaos roiled money markets, sending short-term interest rates surging. Traders rushed to profit from the dislocations, knowing that the Federal Reserve would likely step in quickly to calm the market for repurchase-agreement transactions that was ground zero for the turmoil.

In London, BlueBay Asset Management’s Kaspar Hense said the $65 billion firm profited from the widening in a key forward rate spread. In Newport Beach, California, Janus Henderson Group’s Nick Maroutsos added $35 million in dollar-yen forwards to the firm’s short-duration exchange traded fund as the contracts suddenly sported a juicy yield. At Austin Atlantic Asset Management, Sean Kelleher’s AAAMCO Ultrashort Financing Fund reacted to a surge in demand for cash.

“If you’re cash rich, you can have some very good short-term investments,” said Maroutsos.

US money-market interest rates surged Tuesday as cash reserves in the banking system remained out of balance with the volume of securities on dealer balance sheets. That meant a scarcity of financing in the repo market, a common source of funding for primary dealers who had loaded up on Treasury bills and notes after recent large auctions.

For Hense, the repo drama presented an opportunity to exit a position in which he had sold December eurodollar contracts and received 2-month 1-month overnight index swap rates, a trade that would make money as the spread between the two widens.

The widening in what’s known as the FRA/OIS spread generally signals stress in the credit markets, such as banks facing challenges in accessing short-term funding or systemic credit stress.

Hense had entered the trade through “a variety of funds” in the second quarter when stress was building up in the money markets. The pressure was fuelled in part by an increase in bill supply earlier this summer. He believed a widening in the spread was probable because quarter-end and year-end funding stress tends to appear seasonally due to the Fed shrinking its balance sheet. The bet payed off this week — albeit because of an unforeseen catalyst.

The Fed responded by reintroducing repo operations this week, and plans to continue them at least until October 10. That puts the opportunity for another trade like this in doubt. Hense said that a decision to re-enter the position depends on how credible the Fed is in providing sufficient liquidity.

“We have very likely seen the worst apart from quarter-end spikes,” Hense said.

Kelleher, who co-manages the AAAMCO Ultrashort Financing Fund, said he was able to provide cash-hungry clients with funds at a higher rate, though nowhere near as high as what was being charged for overnight repo markets, where rates got as high as 10 per cent.

“Most of our financing was out for a week, so those didn’t spike nearly as much,” he said. “And in some cases, we weren’t even charging as much as the Street was because of the nature of our investors — we don’t need to. We don’t have to match what the Street is doing because the Street probably had more uncertainty about the stability of their cash, versus ours.”

At Janus, Maroutsos’s trade for the firm’s $1.1 billion Janus Short Duration Income exchange-traded fund essentially involved loaning out dollars in exchange for holding yen cash for one week. The manager, who took over what had been Bill Gross’s bond fund at Janus in March, is not convinced the repo issue is fixed permanently.

While the US is adding liquidity to stabilise rates, that won’t be sufficient to prevent an even more-acute dollar crunch at year-end, according to Maroutsos, so this type of opportunity may arise again in December.

“The market, the Fed, large asset managers that have been on the tape talking about the funding stress, I don’t think they fully comprehend what is fully going on in the market or recognise how big of a problem that can be,” said Maroutsos. “Over year-end, I think we’re going to see this thing really move higher, both in repo and in currencies.” Bloomberg