Update on US fixed income market conditions ahead of the election

Published on 26 October 2020

With the US election on 3 November 2020, one might expect America’s fixed income markets to be getting choppy. While equity markets show some heightened activity, a combination of Federal Reserve policy and deposit growth at banks is supporting liquidity in the market.

Dwayne Middleton, global head of fixed income trading at T Rowe Price, outlines the market conditions for US bond traders today, and the optimal ways for buy-side traders to get best execution for their investors in the market today.

Dan Barnes Welcome to Trader TV, I’m Dan Barnes. With the US election coming up on the 3rd of November, we might expect markets to be volatile. We’re going to speak with Dwayne Middleton, the global head of fixed income trading at T Rowe Price, to understand liquidity conditions and volatility conditions in US fixed income markets this month. Dwayne, thanks for coming on the show.

Dwayne Middleton Hi, Dan, thanks for having me.

Dan Barnes So tell us, how would you characterize liquidity conditions in U.S. fixed income across credit and treasuries this month?

Dwayne Middleton Unlike last fourth quarter where you had a lot of fluctuation in the repo market, I don’t think that’s going to occur this year, because of what the Federal Reserve has done and the deposit growth at banks. So I think there’s plenty of liquidity in the system to alleviate any kind of ‘regulatory gymnastics’ that typically occur in the fourth quarter. I think that’s one positive for liquidity conditions. I think dealers’ balance sheets are still pretty robust, they may not be deploying them fully, but if there is a left tail event, the Federal Reserve is really kind of positioned to deal with any kind of ‘plumbing’ issues, so to speak.

Dan Barnes And markets particularly volatile now?

Dwayne Middleton If you look at equity volatility I think we’re up around 28, 29 on the VIX. So clearly there’s some expectations and that could be the US election, Brexit, COVID cases increasing, that sort of thing – to me, those are all kind of known outcomes. It’s hard to see a return to March-level volatility just given all this central bank activity that’s occurred. And in addition, the rally in spreads that we’ve seen. If you look at rate volatility fx, the 10-year yield, the variance has only been roughly 30 basis points, and I think that’s a a decade-low in terms of yields changing. If you look at the retracement in credit spreads, it’s roughly 70 to 75 percent. Using the Barclays Indices were roughly at 120 basis points on an OAS basis. If you look at high-yield using the same kind of benchmark, we’re roughly at a 103 dollar price, so clearly there’s been a pretty dramatic recovery. Technicals in credit markets are as strong as they’ve ever been, so that’s two reasons. Foreign buying activity has been increased while you’ve had a flood of supply, and net debt on aggregate has increased. You can start to paint a picture that a lot of that supply is going to start to wane, and some are calling for IG supply to be down 30 percent year-over-year next year. So you’re almost shaping up where it’s going to be hard to source alpha opportunities.

Dan Barnes It’s really interesting how that central bank interaction with markets is playing, because you’ve got a certain amount of fixed income asset-buying by central banks, but actually at quite low levels. But just the willingness to support the market seems to be having a significant effect. Then, of course, you’ve got very low rates. So all in all that seems to have dampened down volatility. That’s what we’re saying?

Dwayne Middleton The Federal Reserveeral Reserve credit programs were a backstop measure and really kind of taking out that left side or negative tail risk. So once you remove that, that got people comfortable that they could make their investment decisions. I’d say from March to maybe July, it was probably more of a beta play in terms of just getting aggregate exposure. Now, I think security selection, sector selection are really going to drive that kind of alpha opportunity.

Dan Barnes You mentioned that dealers actually do have some risk appetite. Occasionally we see towards the end of the year, especially when the banks have made a lot of money earlier in the year, they seem to be a bit risk off, because the opportunities there versus the risk isn’t necessarily something they want to take, but it sounds like they still have risk appetite. That’s good.

Dwayne Middleton I think dealers are perfectly willing to make single name, alpha target bets, or take attributes from the buy-side and construct. Portfolio trading is still a growing trend within the credit markets; one-way dealers express their not so much a balance sheet constrained, but they’ll frame the market wider. But to me, that’s an opportunity if you have good price inputs coming into your platform to kind of really be an aggressor inside that bid offer. And I mean, you see that showing up in market access in open trading, for example.

Dan Barnes How is your team achieving best execution in the current conditions? What sort of trading protocols you favoring?

Dwayne Middleton Our consultative conversations with portfolio managers, research analysts has really centered around, what are we trying to accomplish in client portfolios or on a particular order and what’s kind of the best trading protocol to pursue that? So if it’s a vertical slice of a portfolio to manage a cash flow, we might just use the traditional RFQ protocol. But if it’s a single name opportunity where we have a bleep and pretty confident on the level that we want to execute at, we might pursue more of the anonymous or all-to-all trading protocol. Or, in turn, if we get to say attributes from a portfolio manager, we might look at a portfolio trading opportunity. So it’s really embracing all the tools that we have available to ensure best client outcomes.

Dan Barnes So having a wide tool kit is really the key?

Dwayne Middleton I think so. I mean, we’re in this kind of multi-asset, fixed-income world and you need as much flexibility as possible.

Dan Barnes That’s great. Dwayne, thanks very much!

Dwayne Middleton Sure. Thank you. Thanks for having me.

Dan Barnes I’d like to thank Dwayne for his insights and, of course you for watching. To catch up on our other shows, or to subscribe to our newsletter, go to TraderTV.net or ETFTV.net.