When we last looked at the blowout in US short-term funding rates, most notably Libor, which has been broadly attributed to regulatory reasons ahead of the October 14 money fund reform deadline, we pointed out that with trillions in debt tracking Libor, it was only a matter of time before something snapped.
Since then Libor has slowed down its dramatic ascent, so far plateauing in the low 0.8% range, however, the materially "tighter financial conditions" have remained.
Yet while many have been looking for clues in the US banking sector about financial stress, they have been so far unsuccessful. The reason for that, as IFR reports, is that they were looking in the wrong place.
Instead, it is not US but Japanese megabanks who have emerged as the biggest victims of a worsening squeeze in the US $1 trillion commercial paper market, "as high swap costs leave them with few satisfactory alternatives for dollar funding."
As we reported a month ago, investors have pulled billions out of prime money-market funds ahead of new Securities and Exchange Commission (SEC) regulations aimed at preventing a repeat of the liquidity crisis following the collapse of Lehman Brothers in 2008. In anticipation, investors have slashed their allocations to prime funds, the main buyers of commercial paper and certificates of deposit from corporations, including Japanese lenders.
So far US banks have escaped largely unscathed, but the higher funding costs and shrunken market are hitting Japanese banks particularly hard, IFR reports, as they have been sourcing as much as a third of their U.S. dollar liquidity in the short-term U.S. market. Citigroup estimates Japanese banks have about $125 billion to $150 billion of CP and CDs maturing before the end of September.
Adding Libor surging insult, to profit-draining NIRP injury (recall that Japanese banks have seen their profits shrink as a result of the BOJ's recent implementation of negative rates), rising U.S. dollar funding rates pose a further threat to profitability at Japanese banks. Corporate clients are also at risk, as lenders look to pass on the higher costs.
To be sure, some Japanese lenders have been trying to pre-empt the blow from reforms and the Libor blow out. Sumitomo Mitsui Financial Group cut its global CP and CD funding by $7 billion in the year to June, while a $28 billion jump in deposits outpaced a $19 billion increase in lending globally, according to Deutsche Bank. As a result, its loan-to-deposit ratio shrank from 149.6 percent in March 2015 to 135.5 percent at end-June. Mitsubishi UFJ also saw its ratio fall to 115.1 percent from 117.8 percent in March 2015 on the back of a rise in deposits.
In the short term, however, Japanese lenders will be unable to raise enough from deposits to replace the U.S. money markets. Prime money-market funds slashed their holdings of Japanese securities to $115 billion at the end of July, down 25% from $153 billion two months ago, according to ICI. Previously second to only the U.S. by country of issuer, Japan has now fallen to third behind France.
Being increasingly locked out of money markets means that beyond paying up subsantially for U.S. dollars, Japanese banks have few options. Leverage requirements mean global banks are reluctant to provide repos, while foreign-exchange swaps would be a more expensive way to access U.S. dollar funding, said Koichi Sugisaki, a rates strategist at Morgan Stanley MUFG Securities. Three-month CP and CDs now cost roughly 80bp-90bp on an annual basis, but three-month FX forwards have also become more expensive at around 1.5 percent per year, he said.
The surge in Libor, which has also resulted in a spike in the cross-currency basis, has also meant that Japanese buyers are increasingly shying away from US Treasuries which when fully FX hedged no longer generate a notably yield pick up as we reported earlier.
FX hedging costs are at their highest since the financial crisis. The three-month JPY/USD forward is now at -39 pips, the lowest since December 2008. The more negative the reading, the more expensive it is for Japanese issuers to swap yen to U.S. dollars. It also means that the shortage of dollars, from a Japanese perspective, has never been greater.
Rising Libor rates could push FX swap rates out further by the end of this year, Sugisaki estimated. "An increase of the cost of funding in CP and CDs would be definitely negative for the banks," he said. "For the Japanese banks, it's going to be very tough."
One option for Japanese banks is to access US dollar bond funding, by directly selling short-dated, US-denominated bonds, which could provide Japanese banks with some respite from short-term dollar funding pressure. "Japanese banks could consider issuing short-end bonds from the operating bank level in the future to meet short-term liquidity needs as an alternative to CP/CDs,” said Masanori Kato, head of debt capital markets for J.P. Morgan in Tokyo. "Short-term notes would be a possible alternative avenue, and demand would be there for it as Japanese banks are seen as a safer haven due to Brexit concerns."
He suggested that, although it was difficult to say whether issuing U.S. dollar bonds could be cheaper than using FX forwards, the possibility remained that U.S. dollar bond funding might become more competitive. Some high-rated European banks have already taken this approach, finding that two-year or three-year bonds offer similar funding costs to CP.
However, as IFR notes, this option will have to be tested first, as Japanese banks have rarely issued U.S. dollar bonds at tenors of less than three years.
The strain on short-term funding is not expected to end soon, with Citigroup estimating that three-month Libor could rise another 5bp-10bp before October 14.
In the absence of cost-effective alternatives, Japanese banks will have to continue issuing CPs at a higher cost, pressuring their profit margins, leading to an even greater shortage of US dollars, higher Libor rates, and so on, until the Libor spike spills over across the Pacific and claims its first US and European banking victims.