Libor-OIS Blows Out As Libor Rises Above 2% For The First Time In 10 Years

There are those who will breathlessly tell you to ignore all marginal changes in the market, such as the "tiny" move in the VIX from 10 to 15, only to suffer a 96% loss on their inverse VIX ETF when the "tiny" move becomes just a "little bigger" after a short squeeze cascade is triggered because small moves are that much more more acute when starting from a small base. They are also those who will tell you to disregard "modest" moves in the FRA-OIS, the conventional metric for "funding pressures" as we said last week  - "after all the move is tiny in the context of normal times" - yet forget to mention that the Fed's balance sheet is $4.4 trillion, or 5x higher than normal, accentuating even the smallest rate moves. In fact, these are all the same people who will tell you to ignore all changes in the market, no matter how small (or not), until something snaps and then they lecture you how obvious the crash was all along

Meanwhile, we'll just note that the same Libor-OIS (or its intraday updated cousin, the FRA-OIS) we highlighted less than a week ago  when it was "only" 32.7bps, has blown out by 8 bps in just the past week, and is now over 40bps, the widest since October 2016 and blowing out, a huge move when one considers the hundreds of billions in TRS and other layered swaps levering even one basis point.

Then there is Libor: as of today, the benchmark 3M USD Libor has risen above 2% for the first time since December 2008, as financial conditions, if only in the unsecured dollar funding market - which just happens to benchmark trillions in securities - becomes dangerously tight.

Putting the move in context, one week ago, JPMorgan and BofA said they expect 3M Libor to hit 2% by end-1Q; it get there 5 weeks early as the bond vigilantes wake up.

So what is going on? As we explained not once but twice last week, there are fears that repatriation flows will soak up all much of the excess liquidity on the front end as companies rush to delever.

Then there is the recent surge in bill issuance: as Citi wrotes last week, there is evidence that last week’s $200bn surge in T-bill and Treasury issuance "may be contributing to a tightening in $ financial conditions" which represents a negative for credit.

As Citi explained, in addition to the direct effect of the issuance on real yields, when the US Treasury raises money it initially deposits it in the Treasury General Account (TGA) at the Fed. Rather than growing its balance sheet, the Fed effectively sterilizes these deposits with a reduction in private sector banks’ excess reserves. This in turn reduces the capital available to be deployed in markets for cross-currency and other arbitrages, and means there is a direct link between the rise in the TGA and this week’s rise in $ Libor-OIS (chart below, left hand side).

Another adverse effect, one we discussed last week, is that this also feeds through into a more negative €-$ cross-currency basis (shown below), making FX-hedged purchases of US securities more expensive for foreigners. According to Citi estimates, a rise in the TGA to around $350bn ought to add 2-4bp to the basis; however Citi also suspects the effect may prove considerably greater (chart above, right hand side).

As we said last Friday, "the irony is that the tighter the USD-funding conditions get, the wider the FRA/OIS spread will drift, the less global demand for FX-hedged US paper there will be, the higher US Treasury rates rise to prompt demand, until eventually yields push so high that the already stretched correlation between rising yields and stocks finally snaps, leading to an equity correction (or crash), which in turn forces the Fed to ease financial conditions, resetting the cycle all over again."

Bottom line, in addition to following the 10Y, the USD, and of course the S&P500, add Libor/OIS to your watchlist, especially now that it is on the verge of breaching a 5 years trendline, which would then go back to the European financial crisis...

... it may prove the most forward-looking canary in this particular coal mine.