Until two days ago, the critical level for both the Libor-OIS and FRA-OIS spread was the "psychological level" of 50bps. This, however, was breached on Wednesday when as we reported Libor pushed significantly higher without a matching move in swaps. And yet, despite the sharp push wider, both spreads remained below the peak levels observed during the European sovereign debt crisis of 2011/2012, with some speculating that open central bank swap lines at OIS+50bps would limit the move wider.
That changed this morning when the day's 3M USD Libor fixing jumped higher for the 27th consecutive session, rising to 2.2018% from 2.1775%, and the highest since December 2008. And, as has been the case for the past two months, the move was again not matched by OIS, resulting in the Libor-OIS spread jumping to 51.4bp, surpassing the 2011/2012 highs and the widest level since May 2009.
At the same time, the FRA-OIS also spread spiked to a new multi-year high of 53.3bps, the highest in years.
Commenting on the move, NatWest Markets strategist Blake Gwinn urgent clients "don't fade FRA/OIS’ recommendation is still in effect, but certainly on watch", adding that the most frequently asked question this week has been "where will Libor stop?"
While the clear answer - at least for now - is "not here", Gwinn repeated what we said on March 14, noting that the Fed’s central bank swap lines should "theoretically put a cap on USD funding rates" as the banks are authorized to offer terms out to three months at OIS+50bp, and also echoed BofA's comments on the topic, noting that among the impediments are haircuts that add roughly another 10bp to the effective rate, the stigma of going to central banks for funding, and lack of availability of swap lines.
And yet, should Libor keep pushing wider, the Fed will have to notice.
As we said two days ago, the Federal Reserve is increasingly monitoring the rise in LIBOR and is trying to understand what exactly is driving it. In fact, in the most recent dealer survey the Fed specifically asked about the 3m L-OIS spread widening.
As a quick reminder, we previously laid out the 6 possible reasons for the ongoing spread blow out: 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:
- an increase in short-term bond (T-bill) issuance
- rising outflow pressures on dollar deposits in the US owing to rising short-term rates
- repatriation to cope with US Tax Cuts and Jobs Act (TCJA) and new trade policies, and concerns on dollar liquidity outside the US
- risk premium for uncertainty of US monetary policy
- recently elevated credit spreads (CDS) of banks
- demand for funds in preparation for market stress
Those who say "don't panic" have been focusing entirely on the first three, while traders are increasingly concerned that the answer may be found in the latter, and far more concerning, three explanations.
To be sure, the wider the spread blows out, the more likely it is that something far less benign is causing the move than merely the surge in T-Bill issuance (which the market is well aware will subside soon, and can price it in), or simple supply/demand mechanics for CP/CD.
In fact, should Libor keep rising and LIBOR-OIS blowing out, it won't matter what is causing it as banks will suddenly find themselves in a severe funding shortage, because just like the VIX-market "tail wags dog" relationship - which took the market about 3 years to figure out despite repeated warnings by this site - so the tighter financial conditions become, the wider the spread will move in a similarly reflexive move.
Unless the Fed intervenes of course... which with Libor blowing out so aggressively, is precisely what traders are wondering may happen.
The Fed is certainly aware that the around 35bp increase in 3m LIBOR-OIS since mid-November equates to roughly 1.4 hikes. However, according to BofA, the Fed is probably monitoring LIBOR in the context of broader financial conditions and is not yet sufficiently concerned by the recent tightening to adjust policy. Indeed, the Chicago Fed financial conditions index has tightened, but still shows conditions are much easier vs when the Fed started tightening policy in 2015.
In other words, while the Fed is aware of the blowing out Libor spread, it is unlikely to intervene - i.e. cut rates - unless stocks finally notice and tumble as a result of the sharply tighter monetary conditions on the front end.