Over the weekend, when we noted the ongoing blow out in the Libor-OIS spread, we asked whether a dollar funding crisis is emerging , now that this traditional indicator of monetary tightness and systemic credit stress has blown out to levels last seen during the European sovereign debt crisis of 2011.
One day later, Bank of America’s rates strategist Mark Cabana used the same chart as his “chart of the day”, noting that “the 3-month USD LIBOR-OIS spread recently widened sharply to levels not seen since the European peripheral crisis in 2011-12.”
Noting that while it is hardly indicative of “heightened bank credit concerns, but rather reflects a number of factors that have worsened the supply-demand backdrop and impacted the price of funding”, BofA then said it expects the widening in 3m LIBOR-OIS will likely get modestly worse before it gets better due to structural shifts in money markets.
We are not expecting a quick retracement due to (1) a possible acceleration in offshore corporate cash repatriation, (2) uncertainty over how quickly a new marginal buyer will emerge or issuer diversification will occur and (3) ongoing reserve draining. We expect higher overall front-end borrowing rates to persist for some time, but do not expect this tightening in conditions to materially impact the Fed’s gradual rate hiking path.
According to Bank of America, the recent 3m L-OIS spread widening to four factors, in order of priority:
- Elevated front-end supply: Following the Congressional agreement to suspend the debt limit on 8 February the US Treasury has issued a whopping net $283bn of Treasury bill supply inclusive of the settlements this week (Chart 2). For context, the amount of supply over the past five weeks has exceeded the net bill supply in 2017 by over two times. The elevated front-end supply has caused Treasury bills to cheapen notably vs OIS (Chart 3). This has supported a cheapening of other money market products and forced banks to raise their borrowing rates to attract funding, especially since financial CP outstanding recently hit the highest since MMF reform (Chart 4).
- Repatriation: As discussed here, many corporates are likely in the process of building liquidity ahead of a draw down in large cash pools overseas. One way to evidence this activity is through offshore USD MMF. AUM in offshore prime USD MMF increased from $240bn to $320bn after the 2016 election likely as expectations for repatriation built (Chart 5). As the tax law moved to completion late last year offshore USD MMF fund managers became defensive anticipating future corporate outflows (Chart 6).
- Defensive positioning: Onshore institutional prime MMF WAMs have recently declined reflecting defensive posturing amid elevated front-end supply and in anticipation of the March FOMC rate rise (Chart 7).
- Reserve draining: The Fed’s balance sheet unwind and recent build in the Treasury’s cash balance will serve to drain excess reserves and tighten funding.
Meanwhile, going back to our most recent post on the Libor-OIS spread, we noted that while the overall move wider was expected, the speed of the blow out has taken most analysts by surprise, and the result has been a scramble to explain not only the reasons behind the move, but its sharp severity. Abd while this is a simplification of the various catalysts behind the spike in Libor-OIS, here is a quick summary of what is going on – the expansion of Libor-OIS and basis swaps have been impacted by a complex array of factors, which include:
- an increase in short-term bond (T-bill) issuance
- rising outflow pressures on dollar deposits in the US owing to rising short-term rates
- repatriation to cope with US Tax Cuts and Jobs Act (TCJA) and new trade policies, and concerns on dollar liquidity outside the US
- risk premium for uncertainty of US monetary policy
- recently elevated credit spreads (CDS) of banks
- demand for funds in preparation for market stress
To be sure, in recent posts…
- Why US Tax Reform Will Put Even More Pressure On Dollar Funding Markets
- Libor-OIS Blowing Out On Rising Repatriation Concerns, Collapsing Front-End Funding
- Libor-OIS Contagion: As Spread Blows Out, It Starts To “Infect” Other Markets
- Libor-OIS Blows Out As Libor Rises Above 2% For The First Time In 10 Years
… we have taken a detailed look at each of these components, of which 1 thru 3 are the most widely accepted, while bullets at 4 through 6 are within the realm of increasingly troubling speculation, and suggest that not all is well with the market, in fact quite the contrary, and would imply that contrary to what BofA and various other commentators have suggested, bank credit concerns are indeed becoming a relevant issue.
Still, as we explained on Sunday, whatever the cause of the ongoing blow out in Libor-OIS, this move is having defined, and adverse, consequences on both dollar funding and hedging costs. This alone will have a severe impact on foreign banks, because as DB wrote recently, “the rise in dollar funding costs will damage the profitability of hedged investing and lending by [foreign] financial institutions. Most of the bond investors we have talked with shared a strong interest (and concern) in this topic.” However, the most immediate consequence is that it is now more economical for Japanese investors to buy 30Y JGBs, with their paltry nominal yields, than to purchase FX-hedged 30Y US Treasuries which as of this moment yield less than matched Japanese securities. The same logic can be applied to German Bunds, as the calculus has made it increasingly unattractive for European investors to buy FX-hedged Treasuries.
Meanwhile, in the forward space, the latest jump higher in 3-month USD Libor prompted a fresh wave of selling across Mar18 eurodollar futures…
…with the higher fix pushing FRA/OIS over 50bp for the first time since 2012.
And while Libor-OIS is moving fast, the FRA/OIS has widened even more dramatically, rising as much as 8bp above spot Libor-OIS in recent days.
Aside from reflecting expectations of a wider Libor-OIS, the FRA/OIS widening could have been driven by the fact that large traders used Eurodollars instead of fed funds futures to express views of a more aggressive Fed cycle and a higher terminal rate. An evidence of this is that FRA/OIS moved considerably wider the day after the January jobs report and also after the January CPI report.
As previously, we urge readers to keep a close eye on this sharp move wider, because whether it is due to relatively innocuous reasons such as the 4 listed by BofA, or the three far more troubling ones, namely i) the risk premium for uncertainty of US monetary policy, ii) recently elevated credit spreads (CDS) of banks and iii) demand for funds in preparation for market stress, dollar funding is becoming increasingly problematic, and absent a sharp tightening in the Libor-OIS and FRA-OIS spread, while bank credit concerns may not have been the catalyst for the sharp spike, it will be banks that are eventually impacted by what is increasingly emerging as an acute tightening in short-term funding markets and/or a global dollar shortage.
What happens next is critical.
As BofA notes, it is difficult to imagine levels moving materially higher than 50bp due to the presence of central bank liquidity swap lines. The Fed currently maintains bilateral FX swap lines with the ECB, BoJ, and other major central banks. The price to access these swap lines has three parts: (1) OIS of borrowing tenor +50bp; (2) haircut on the posted collateral; and (3) associated stigma. As such OIS +50 should serve as a soft upper bound on how high funding costs can rise though it is certainly possible the 3m L-OIS spread could rise to 60bp after collateral haircuts and stigma concerns are taken into consideration.
As such, should either L-OIS, or FRA-OIS move notably wider beyond 50bps, and should CB swap lines remain unused, it may be time to throw away all those explanations you have read that say “don’t panic” the move is perfectly normal, and to consider the alternative.
Finally, the move in Libor alone will soon start attracting attention as it is the benchmark rate for several hundred trillions in floating-rate debt.
It is worth noting that the Fed itself is monitoring the rise in LIBOR and is trying to understand what exactly is driving it (in their most recent dealer survey the Fed specifically asked about the 3m L-OIS spread widening). The Fed is certainly aware that the around 35bp increase in 3m LIBOR-OIS since mid-November equates to roughly 1.4 hikes. However, according to BofA, the Fed is probably monitoring LIBOR in the context of broader financial conditions and is not yet sufficiently concerned by the recent tightening to adjust policy. Indeed, the Chicago Fed financial conditions index has tightened, but still shows conditions are much easier vs when the Fed started tightening policy in 2015.
The Fed would likely be much more concerned about the rise in LIBOR if it reflected heighted bank credit concerns rather than structural supply/demand dynamics at the front end of the rates curve… which may well be the case if as noted above, the blowout persists beyond 50bps.
They will also likely become concerned with financial conditions only if it spills over into broader corporate borrowing/investment activity or begins to wane on consumer or business confidence. Overall, consensus believes that the rise in LIBOR is not yet sufficient to derail the Fed from their “gradual tightening cycle”, but they will likely be more attuned to financial conditions given the recent rise.