T-Minus 7 Days To A LIBOR-Induced Liquidity Crunch?
Zero Hedge has been discussing the ongoing liquidity constriction around the world over the past month, focusing on Europe and China, where conditions range from icy to outright frozen. One country that has been largely ignored, is our very own USA, where despite the Fed's ongoing liquidity flood, the last few days have seen short-term secured funding in the form of Top Tier Commercial Paper once again jumping to near 2010 highs at 0.43% (see chart). This is in stark contrast with ultra short-dated Treasuries, where 30 Day Bills are just barely yielding 0.05% (and were as low as 0.02% a few days prior).
Yet for all domestic jitters, it appears that the next source of an (il)liquidity crunch will once again come from Europe. As Barclays' Joseph Abate notes, there is one event is on the horizon which could send Libor rates as high as 50% higher. And that event will occur on July 1 - the 1 year anniversary of the ECB's Long-Term Refinancing Operation.
This 371 Day LTRO was created just under a year ago by the ECB to add €442 billion in liquidity to front-end markets. It is precisely this LTRO that facilitated not only the decline in the FRBNY's FX swaps, but the gradual drop in dollar Libor to all time lows. The program was so successful that the ECB followed it up with two other one-year LTROs, yet both much smaller: one for €75 and one for €97 billion. Yet the Halcyon days of well over half a trillion in excess CB-provided liquidity are ending on July 1, and the roll off will be a critical event, which could set off yet another liquidity crunch first in Europe, and then everywhere else.
The first consideration is that the facility will not roll into a comparable unlimited 1 Year tender, but instead into a much shorter 3 month operation. As Abate points out: "Market attention is focused on how much of the €442bn stays at the ECB and how much leaves the program: currently there is about €300bn “surplus” liquidity in the euro area market, and so a full rollover is not theoretically needed."
And as nobody but JCT really knows what quality collateral is pledging any one euro of circulating money, especially post the complete loosening of A-rating triggers to pledging sovereign debt post the Greece bankruptcy (unlike the broader media, we don't mind calling a spade a spade), the willingness to unwind the facility will speak volumes about Europe's banks:
[Barclays] European analysts reckon that based on the level and regional composition of the liquidity on deposit at the ECB, perhaps as much as € 150bn could leave in search of cheaper financing in the market. Unfortunately, the ECB’s balance sheet figures are less transparent than the Federal Reserve’s, so analysts do not have a strong sense of what types of collateral have been pledged into the facility. Obviously, the more government securities pledged, the more likely it is the 3m replacement LTRO will be considerably smaller than the €442bn rolling off.
Yet no matter how much of the full amount rolls off, there will be an immediate "cliff" event in liquidity needs as the public funding market will be replaced by the private: sorry, Jean-Claude, you can't have your public cake and have the private sector eat it (the cake, not the sector).
Any paper leaving the ECB will need to be funded in the market – which given the global reach of many participating banks, should put upward pressure on Eonia as well as dollar Libor. All things equal, however, the smaller the replacement LTRO is relative to the €442bn roll-off, the more likely it is Libor will increase from 53bp currently.
Another way of looking at why Libor is set to surge is based on expectations of what is happening behind the scenes, as nobody still have any idea what is really held by the ECB, either in its LTRO, or any other Operational facilities:
Assuming that most of the collateral pledged in the LTRO is lower quality, there might not be much of an exodus out of the facility. Instead, the replacement 3m LTRO could be nearly as large as the original €442bn. Not only would this indicate that banks still have lower quality assets on their balance sheets – but that the decline in market rates since last July has not been broad or deep enough to enable institutions to leave the security of the ECB. Market participants could interpret this as an indication of still high counterparty credit risk. In turn, this would raise FRA-OIS rates – in both Europe and the US as investors reassess credit exposure.
And the piece de resisance is that the imminent disclosure of the European "Stress Tests" will backfire, as they will be announced at a time when liquidity tensions are soaring, and Libor is starting to surge once again.
Credit concerns could also be reignited next month with the release of the EU’s bank stress test results. To the extent that financial markets interpret these results negatively, FRA-OIS might get an additional push higher.
Will all this be sufficient to cause an interbank lending crisis in the US, comparable to that enveloping Spain and soon other European countries? At this point it is still difficult to make a determination, although the two opposing forces of Fed reliquification, and private market stress escalation, will once again certainly be locked in a duel, which will definitely have an impact on all risk assets. Perhaps it is this that tension that has been keeping the market on edge. Either way, keep an eye out on Libor, CP (both US and European), and ultra short dated Bills: despite the Fed's interventions, the broader market will overwhelm a liquidity intervention any day, and the Fed may soon find itself with little if any options to restore liquidity in the broader capital markets, increasingly losing any and all credibility, precisely courtesy of seemingly endless Central bank intervention.