We've been saying it for over a month: the most important, if widely underappreciated, factor for risk assets has been the surge in Libor and the blow out in the Libor-OIS spread, or short-term funding costs, which impacts everything from bank lending costs to the marginal cost of trillions in floating rate debt.
Yesterday, Citi's Matt King confirmed as much in a lengthy note explaining why the blowing out Libor, and Libor-OIS spread, are sending increasingly ominous signals:
LIBOR is still the reference point for the majority of leveraged loans, interest-rate swaps and some mortgages. In addition to that direct effect, higher money market rates and weakness in risk assets are the two conditions most likely to contribute towards mutual fund outflows. If those in turn created a further sell-off in markets, the negative impact on the economy through wealth effects could be greater even than the direct effect from interest rates.
Now, another bank has joined the growing chorus of warnings over the soaring Libor and Libor-OIS.
Jonathan Garner, Morgan Stanley's Chief Strategist for Asia and Emerging Markets , told Bloomberg that the rising Libor rates is a bigger concern right now than a more hawkish Federal Reserve, and in fact, is "the story of the year."
As we have documented nearly daily, most recently yesterday, Libor has been rising since Feb. 7 for 31 consecutive sessions, reaching 2.2711% this morning, the highest since 2008. Meanwhile, its gap over risk-free rates, known as the Libor-OIS spread, has more than doubled since the end of January to 55.6 basis points, a level unseen since 2009.
"That’s a key reason why markets have struggled. The acceleration in the private borrowing market is the story of the year, not the Fed," Garner told BloombergQuint in an interview.
What I think is really interesting is that in the private, LIBOR markets, the USD Libor has already moved far more aggressively than Fed Funds, so if you look at 6M USD Libor, it's actually reached 2.375% whereas the Fed is likely to raise Fed Funds by a quarter of a point to 1.75%, so we've actually already for the interest rate that really determines corporate costs are experiencing a very significant increase in interest rates. So unless the Fed is in some ways super dovish, I think we're already looking at a significant tightening of monetary policy in the US and in addition China is tightening monetary policy at the same time and this joint tightening is a key reason why we are so cautious on markets.
To those who say that all that matters today is whether the Fed is hawkish or dovish, and whether it suggests 3 or 4 hikes for 2018, Garner counters that "it's not actually the Fed that's in the driver's seat in relation to corporate costs of funding. The Dollar Libor markets, which is actually where corporates borrow, have already moved to 2.375% for 6 month money and that's a key reason why markets have struggled, because the acceleration and the tightening up of private markets is the story of the year, not the Fed."
What does that mean for global markets?
Our thesis for the year was a rougher ride and we had a number of things we're concerned about, the reduction in the Fed's balance sheet and actually the fiscal easing in the US is probably one of the reasons why private money markets are getting so tight. There's some evidence that the Treasury Bill issuance is actually crowding out private borrowers to some extent and at the same time we have exceptionally high valuations for non-financials part of global equities, and overly optimistic earnings expectations.
Garner concludes by echoing what Morgan Stanley's chief economist, Mike Wilson, said on Monday: "this sets us up for a market which we are pretty sure reached its highs for the year in the euphoria of the third week of January and the rest of the year is quite simply going to be a tough market."
It could get much worse: not only does Libor tend to be a 3-month leading indicator to the dollar, which as Citi showed yesterday would mean a surge in the USD, sending shockwaves across global risk markets...
... but just as concerning is that the global funding shortage indicated by the soaring Libor-OIS is finally hitting financial credit risk, and as we showed earlier today the IG OAS is once again moving wider...
... while bank CDS have spiked to 6 month wides.
But the worst aspect of this sharp tightening in financial conditions is that virtually nobody has a coherent explanation what is causing it, or what the outcome will be: "We usually don’t see this kind of divergence in rates without some sort of credit issue," said Margaret Kerins, head of fixed-income strategy at BMO Capital Markets Corp., referring to the surge in Libor-OIS. "At what point does all this become damaging and how far does it go? That is the issue."
We conclude with a quote from Brean Capital's Russ Certo: "There has been sort of the perfect storm of factors tightening financial conditions."