Why Tariffs Spurred a Dash for Cash

Our analysts Vishy Tirupattur and Martin Tobias explain how the announcement of new tariffs and the subsequent pause in their implementation affected the bond market.

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Vishy Tirupattur: Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's, Chief Fixed Income Strategist.

Martin Tobias: And I'm Martin Tobias, from the U.S. Interest Rate Strategy Team.

Vishy Tirupattur: Yesterday the U.S. stock market shot up quite dramatically after President Trump paused most tariffs for 90 days. But before that, there were some stresses in the funding markets. So today we will dig into what those stresses were, and what transpired, and what investors can expect going forward.

It's Thursday, April 10th at 11:30am in New York.

President Trump's Liberation Day tariff announcements led to a steep sell off in the global stock markets. Marty, before we dig into that, can you give us some Funding Markets 101? We hear a lot about terms like SOFR, effective fed funds rate, the spread between the two. What are these things and why should we care about this?

Martin Tobias: For starters, SOFR is the secured overnight financing rate, and the effective fed funds rate – EFFR – are both at the heart of funding markets.

Let's start with what our listeners are most likely familiar with – the effective fed funds rate. It's the main policy rate of the Federal Reserve. It's calculated as a volume weighted median of overnight unsecured loans in the Fed funds market. But volume in the Fed funds market has only averaged [$]95 billion per day over the past year.

SOFR is the most important reference rate for market participants. It's a broad measure of the cost to borrow cash overnight, collateralized by Treasury securities. It's calculated as a volume weighted median that covers three segments of the repo market. Now SOFR volumes have averaged 2.2 trillion per day over the past year.

Vishy Tirupattur: So, what you're telling me, Marty, is that the, the difference between these two rates really reflects how much liquidity stress is there, or the expectations of the uncertainty of funding uncertainty that exists in the market. Is that fair?

Martin Tobias: That's correct. And to do this, investors look at futures contracts on fed funds and SOFR.

Now fed funds futures reflect market expectations for the Fed's policy rate, SOFR futures reflect market expectations for the Fed policy rate, and market expectations for funding conditions. So, the difference or basis between the two contracts, isolates market expectations for funding conditions.

Vishy Tirupattur: So, this basis that you just described. What is the normal sense of this? Where [or] how many basis points is the typical basis? Is it positive? Is it negative?

Martin Tobias: In a normal environment over the past three years when reserves were in Abundancy, the three-month SOFR Fed funds Futures basis was positive 2 basis points. This reflected SOFR to set 2 basis points below fed funds on average over the next three months.

Vishy Tirupattur: So, what happened earlier this week is – SOFR was setting above effective hedge advance rate, implying…

Martin Tobias: Implying tighter funding conditions.

Vishy Tirupattur: So, Marty, what actually changed yesterday? How bad did it get and why did it get so bad?

Martin Tobias: So, three months SOR Fed funds tightened all the way to -4 basis points