NY Fed President John Williams said yesterday that the worst is over in the repo market despite the Fed clearly was surprised about the recent moves in the US repo market. There has been a narrative inside the Fed that the current $1.39trn in excess reserves were enough to make markets smooth, but the past week has shown why this is not the case. Most of these excess reserves cannot easily be deployed by major banks as their balance sheets are already tight. The largest US banks have all moved one notch higher in the regulatory surcharge brackets since Q4 2018 which means that unless they shrink their balance sheets toward year-end then they will see a 50 basis points surcharge increase. Our view is that USD liquidity will continue to be an issue and tighten further until the Fed is forced to grow its balance sheet again.
The combination of US banks that have to shrink balance sheets, the strong USD, Germany’s economic activity plunging, earnings disappointments and the never-ending US-China trade war is an interesting setup for long volatility in Q4. This is our conviction view for the coming quarter. Either as a hedge for a balanced portfolio and outright directional play. The VIX is currently priced at 14.72.