One of the more perplexing moves in recent weeks has been the rapid collapse in the Libor-OIS spread, traditionally a signal of bank credit risk, which has confused many rates traders due to contradictory signal it is sending in a world in which the Fed is supposedly tightening.
As we pointed out last Friday, one probable explanation for this is the gusher of bank funding availability that the world's central banks (and even more so China) has unleashed. Nowhere is that more evident than in the total decoupling between "easing" financial conditions, and "tightening" monetary policy.
... something which Goldman itself pointed last week, when it remarked that its financial conditions index was the 'easiest' it has been in 2 years.
Furthermore, another potential explanation for the plunge in the spread emerged two weeks ago, when DB's rates strategists suggested that it could be a function of Japan's sudden revulsion toward US paper, and especially hedged Treasury exposure, which Deutsche pointed out resulted in a sharp tightening in the JPY cross-currency basis, which in turn compressed Libor-OIS.
Now, in a follow up note, Deutsche picks up where it left off at the end of April, and highlights what we documented last week, namely that since peaking last September at 44bps, 3m Libor-OIS has collapsed each time the market got excited about higher rates. In fact, whenever the fed funds implied probability of a rate hike jumped just prior to an upcoming FOMC meeting, a drastic narrowing of Libor-OIS ensued.
So the question then is what do rate hikes have to do with Libor-OIS spreads?
According to Deutsche Bank, the simple answer is that all signs point to the problem being there is weak demand for short-term unsecured borrowing.
As short rates increase, banks have little reason to pay up for short-term funding when they can just term out their debt. The yield curve remains very flat, and demand for corporate debt seems ever insatiable. Although there is still plenty of activity in the commercial paper market, banks are issuing opportunistically only at rates favorable to them. This week, the rate on a 90-day AA financial CP was 1.06%, virtually unchanged since after the March hike.
At the same time, DB notes that cash has been trickling back into prime money market funds. The spread between prime institutional fund yields and government institutional fund yields, although smaller than at the beginning of the year, remains very attractive at 30 bps currently. Of note, six months after money market reforms and exactly zero funds (that we know of) had dropped below a $1 NAV, money market investors are venturing back into prime funds for better returns on their cash. In May, prime money funds saw total assets rise above $400bn for the first time since October.
With these dynamics in mind, a number of things would have to happen to reverse the tightening in Libor-OIS.
- First, if the Fed slows its rate hikes in favor of letting its SOMA portfolio mature, longer rates should climb and the curve would steepen.
- Second, if credit spreads widen, banks would also find it more expensive to issue term debt.
In both these scenarios, bank issuers might bring some of their funding back to the front end, which should drive up CP rates and consequently Libor. Another possibility is if bills cheapen, perhaps driven by an increase in net supply, government money funds could become attractive to investors again and some of their assets might come back from prime funds. This in turn reduces the pool of cash looking to invest in commercial paper, which also drives up their rates.