Is A Dollar Funding Crisis Imminent: Libor-OIS Blows Out The Most Since 2012

Call it the latest paradox of bizarro centrally-planned markets.

On the same day when the Nasdaq hit a new all time high, when the Dow soared and when the payrolls report reincarnated the Goldilocks narrative with one flashing red average hourly earnings headline ("surging jobs + subdued wage growth = an economy that can handle 10Y yields at or above 3.0%"), one of the most closely followed leading indicators of an imminent funding crisis and global credit crunch finally broke above its 6 year range, when the USD Libor-OIS spread jumped 2bps on Friday, rising to 44.23bps.

This was the widest this key spread has been since January 2012, when the latest European sovereign debt crisis was roiling the markets and forced the Fed to open unlimited swap lines with the rest of the world to avoid a global dollar funding crisis and, well, effectively bail out the world - which according to the BIS is synthetically short the USD to the tune of over $10 trillion - for the second time in 4 years.

The move will not come as a surprise to regular readers, as we have been covering it extensively since late 2017:

However, 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.

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:

  1. an increase in short-term bond (T-bill) issuance
  2. rising outflow pressures on dollar deposits in the US owing to rising short-term rates
  3. repatriation to cope with US Tax Cuts and Jobs Act (TCJA) and new trade policies, and concerns on dollar liquidity outside the US
  4. risk premium for uncertainty of US monetary policy
  5. recently elevated credit spreads (CDS) of banks
  6. demand for funds in preparation for market stress

In recent posts (see above) 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.

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.

It's not just rates: the consequences of rising dollar funding costs will eventually impact every aspect of the fixed income market, even if simply taken in isolation due to the ongoing spike in 3M Libor which still is the benchmark reference rate for hundreds of trillions in floating-rate debt.

The reality, however, is that without a specific diagnosis what is causing the sharp surge wider, and thus without a predictive context of high much higher it could rise, and how it will impact the various unsecured funding linkages of the financial system, it remains anyone's guess how much wider the Libor-OIS spread can move before it leads to dire consequences for the financial system.

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And while we wait to see if this sharp move will continue, or it will moderate and perhaps reverse, here is a useful primed courtesy of Bloomberg on "why it matters that the Libor-OIS spread is widening."

Short-term borrowing costs in the U.S. have risen to levels unseen since the financial crisis, and recent moves in two closely watched indicators -- the London interbank offered rate and its spread with the Overnight Index Swap rate -- are causing some consternation. The spread has expanded to its widest level in more than a year, raising questions about whether risks might be brewing within credit markets. While the recent widening may be technical and doesn’t suggest a systemic risk, several factors in funding markets are likely to prevent a “lasting retracement,” according to analysts.

1. What is Libor?

The London interbank offered rate, or Libor, is a benchmark that’s regarded as a gauge of credit market conditions. Every day, various major banks submit to an administrator estimates of what interest rate they would have to pay to borrow in the interbank market, and these are compiled to establish benchmark rates in five different currencies across seven different loan periods. Those benchmarks underpin interest rates on a range of financial instruments and products from student and car loans to mortgages and credit cards.

2. What’s OIS?

The Overnight Index Swap rate is calculated from contracts in which investors swap fixed- and floating-rate cash flows. Some of the most commonly used swap rates relate to the Federal Reserve’s main interest-rate target, and those are regarded as proxies for where markets see U.S. central bank policy headed at various points in the future.

3. Why does the Libor-OIS spread matter?

It’s regarded as a measure of how expensive or cheap it will be for banks to borrow, as shown by Libor, relative to a risk-free rate, the kind that’s paid by highly rated sovereign borrowers such as the U.S. government. The Libor-OIS spread provides a more complete picture of how the market is viewing credit conditions because it strips out the effects of underlying interest-rate moves, which are in turn affected by factors such as central bank policy, inflation and growth expectations.

4. Why are people worried?

The Libor rate for three-month loans in dollars has climbed to 2.03 percent, a level it hasn’t reached since 2008. Its spread over the OIS rate has also widened quite dramatically following a Congressional deal on the U.S. budget and debt ceiling on Feb. 8. That gap widened by 15 basis points in February and was at 44 basis points on March 9. It is the speed of the move that is giving some investors pause for thought.

5. What pushed it up?

Several factors. One has to do with the torrent of Treasury bill supply that the government has unleashed since lawmakers last month resolved their impasse over the nation’s borrowing limit. With that crisis passed, the Treasury has been replenishing its cash balance and that has meant a flood of debt sales, particularly of shorter-dated securities. That has driven up borrowing costs not just for Uncle Sam, but also for other borrowers in the short-term market who rely on instruments such as repurchase agreements and commercial paper.

6. So that’s the only reason it’s widening?

No, the tax legislation passed by Congress in December is also playing a role. The new law offers incentives forcorporations to bring money back to the U.S. that they had previously stashed overseas. Much of that offshore hoard has tended to be kept in short-term instruments like commercial and bank paper, and a dwindling of those overseas cash piles is likely to mean reduced demand for these products. And that means higher borrowing costs.

7. Anything else?

Yes. The Federal Reserve is shrinking its $4.4 trillion balance sheet, which means there will be less reserves sloshing around in the financial system. As the U.S. central bank pulls back from providing support, banks are going to have to compete more for funding, and that could force short-term rates higher.