A Simple Indicator Of Omicron’s Systemic Threat
Omicron has spooked markets off their highs. Stocks, flying high just a week ago, suddenly look fragile and nervous; but, how much of a systemic threat is currently priced into the markets?
In order to answer this, we need to shift our focus away from the headline markets (read: stocks), which have sold off heavily over the past few days, and so far have not been able to recoup their losses. Instead, we need to look for signs of stress in the repo market.
Why? Simply because the repo market is where large investors/traders go to fund and lever up their positions; and where global participants go to for Dollar liquidity. As such, a tightening repo market can spark off a wave of collateral calls, which can quickly snowball into a global financial crisis a la March 2020, where USD liquidity was nonexistent and nobody wanted to own anything remotely risky.
While the repo market is opaque and tough to get data on, a reliable proxy of current stress levels is easily available in the form of UST Bill yields. Since T Bills are the preferred form of collateral used in repo, their yields serve as an excellent proxy for collateral demand.
During a crisis of truly systemic portions, demand for collateral skyrockets as repo participants (and everyone else) hoards whatever Bills and other USTs they have to ensure that they can meet their own liquidity needs. This, together with other participants scrambling to secure adequate collateral to meet rising numbers of margin calls, results in sharply higher prices for Bills and other Treasury securities; that is, much lower yields.
How have bill yields reacted to Omicron? They really haven’t done much at all, especially when compared to what they did when the Covid pandemic first hit in 1Q 2020. Here are 1 month bill yields to illustrate the point:
Moreover, repo fails, that is repo transactions that fail to settle due to one counterparty not fulfilling its part of the transaction (lending cash or pledging collateral), have not spiked. If markets were truly pricing in a systemic threat from Omicron, we would expect to see an appreciable increase in repo failures, but we don’t. Here’s a glimpse at daily repo fails, at least for transactions tracked by the DTCC:
Should you choose to see the current lack of systemic threat from the past few days’ volatility as an opportunity to add to, or initiate, longs, bear in mind that it is still early days in the Omicron wave. It is entirely possible that markets, while not pricing in systemic risk now, can begin to do so if financial conditions deteriorate.
Furthermore, the US yield curve (2s-10s) has not been signaling any kind of meaningful growth for the better part of this year, as it continues to flatten. Regardless of sky high inflation, the falling unemployment rate, and Powell’s increased hawkishness, the bond market begs to differ.
That being said, however you choose to position yourself in response to current market volatility, make sure to be cognizant of how the market you’re trading is trending. For instance, the USD has broadly gained while equities sold off with Omicron, and both the USD and stocks have been trending higher over the past few months. This means that the current Omicron reaction is congruent with the Dollar’s trend, but counter to that in stocks.
In short, it would be prudent to manage your risk more closely, especially if you decide to take a position counter to a market’s prevailing trend. After all, when markets turn during times of uncertainty, they tend to do so in extreme ways.
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