When it comes to ongoing blow out in the Libor-OIS spread, which this morning jumped to another 9 year wide, rising to 54.6bps or the most since May 2009 after 3M USD Libor rose for the 30th consecutive day from 2.2225% to 2.2481%...
... there are two types of analysts (and analysis): those who dismiss the move as merely symptomatic of the deluge in T-Bill issuance and nothing else, a view adopted seemingly by much of Wall Street and most market commentators at a certain terminal sales-funded financial outlet... and those who warn that not only could the move indicate something far more sinister, but what is more troubling, is that no matter what is behind it, financial conditions are becoming increasingly tighter with every passing day, and could potentially result in a funding crisis not only among banks, but also impact the broader.
Our approach has been the latter, and as we showed last week, there are six possible explanations for the sharp move in the spread:
- 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 squarely on the first three, while we, and other traders, are increasingly concerned that the answer may be found in the latter, and far more concerning, three explanations.
Now, in a report by one of Wall Street's most respected analysts and credit strategists, Citi's Matt King echoes our repeated warnings, and writes that "the dramatic rise in $ LIBOR-OIS spread is contributing to a general increase in nervousness around risk assets", a process he thinks "has further to go."
Recall our take of the ongoing blowout from March 11:
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... 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.
Fast forward to today when King picks up where we left off, and notes that while technical in nature, "the widening nevertheless reflects an increasing scarcity of $ funding over and above the Fed’s intended tightening" and "In coming months, we expect this pressure to spread from unsecured money markets and repo to the cross-currency basis." It gets worse:
The bad news is that we think it has further to go in coming months, and expect the effects to become more far-reaching. It contributes to our preference for € credit over $ credit, and expectation that much of the foreign money buying $ credit will shift towards € credit in coming months.
But the biggest risk, and one which those who complacently ignore the move in this critical spread ignore, is the implications it could have on the Fed's overall normalization plans, because as King warns, the sudden tightening in financial conditions "contributes to our bearishness on credit markets as a whole, and conviction that central banks’ carefully stage-managed exit from extreme stimulus is liable to lead to a sharper tightening of financial conditions than they have been anticipating."
In other words, after just 1-2 more rate hikes, not only will it result in a whimpering of the Fed's tightening cycle end, but it could also lead to a bang in the stock market which has similarly been complete ignoring the sharp move in the L-OIS, oblivious to the sharp funding squeeze behind the scenes.
Before we continue, here is King's own take on what is causing the move: spoiler alert - it's not just the surge in T-Bill issuance.
The unprecedented widening in $ LIBOR-OIS has at once awakened unwelcome memories of 2007-8, and yet at the same time left analysts scrambling for explanations. The most commonly cited factor is increased T-bill issuance. But while T-bills may have widened earlier (already in 2017), in the latest move they have actually outperformed vs Eurodollars and Libor rather than underperformed – hardly what would be expected if their issuance was overwhelming everything else. (Figure 4). Presumably the cause is something US-specific, since – in stark contrast with 2007-08 and 2011-12 – LIBOR-OIS spreads in € and £ have been almost completely unaffected (Figure 5).
The immediate explanation which makes most sense to us is a series of changes in $ markets following US tax reform. These seem likely to be structural rather than temporary.
Just as we and many others predicted, repatriation has led to a sharp flattening of the $ credit curve. While last year the flattening seemed to be driven largely by the long end (and expectations of reduced issuance by corporates using bond issuance+offshore cash to fund share buybacks), since February there has been a shift towards a sell-off, with the front end underperforming in beta-adjusted terms (Figure 6). This occurred among both financials and nonfinancials, and was initially concentrated in $, though there are now some signs € credit is trying to follow suit, especially among financials (Figure 7).
What King, correctly, thinks has happened is that corporations with offshore cash piles have gone from seeing those funds as being trapped almost indefinitely to recognizing that they could be called upon to spend that cash at short notice, "most likely on M&A or share buybacks. As such, they have been anxious to reduce the duration of their holdings."
Indicatively, here is a chart from BofA, which shows the 25 largest US HG non-financial holders of overseas cash, which as Q4 held $1.07tr in total cash, cash equivalents, short-term marketable securities and investments, of which $888bn resided abroad. The full breakdown of various cash equivalent holdings is shown below.
The repatriation of offshore cash has been reflected in part in front end bond selling, but the changes are more visible in money markets. In brief, volumes are up, but maturities are sharply down. The average maturity of CP outstandings has fallen – in the case of A2/P2 issuers to post-crisis lows. A similar maturity shortening has been visible in repo markets.
To be sure, the details of this conventional pathway are well understood (we explained them in detail recently), and on the surface, King admits it would all sounds just like a "strong in a teacup."
Yes, a few issuers may find they need to pay up to borrow rather more in short maturities now that corporate treasurers’ cash piles are not at their beck and call, and yes, this may well be a structural rather than a temporary shift. But it hardly constitutes the sort of trigger for broad-based weakness in risk assets that LIBOR-OIS widening is sometimes taken to be.
This is precisely where the apologists stop in the analysis of the consequences of the move wider in Libor-OIS, a position reinforced further by the lack of other signs of stress which have traditionally accompanied LIBOR-OIS widening have so far been absent.
But, as King warns, "this is about to change."
First, the Citi strategist looks at the correlation between the FRA-OIS and the Cross-FX basis, which traditionally have moved together during times of stress, yet which have so far avoided a parallel move. However, not for long though, as King explains:
Normally when one bank funding market gets stressed, multiple funding markets become stressed as borrowers pre-emptively draw down liquidity wherever they can find it – hence the strong correlation between FRA/OIS and FX OIS basis. So widening in $ LIBOR-OIS has typically been associated with widening in the crosscurrency bases, and vice versa. But this year’s pickup in LIBOR-OIS is to date a notable exception (Figure 12).
The reason for this? The Fed is masking the liquidity signal with the $2.1 trillion in excess reserves it has generously handed out to banks. As King notes, until now, banks’ excess reserves have remained ample, ensuring that FX swap markets had abundant liquidity and stayed relatively tame even as CP markets became more stressed.
Note that excess reserves are a necessary but not a sufficient condition for there not to be stress in the system. Banks not only need reserves to be available; they also need to be willing to take advantage of them by engaging in lending activity within the constraints of their capital requirements – leverage ratios in particular. Reserves have taken on added importance in the post-crisis era as a key $ liquidity source foreign investors can borrow, especially for those in lower-yielding DMs.
The cushioning role of reserves also explains why although boosting excess reserves through successive rounds of QE has typically helped to reduce $ funding stresses in the system, draining reserves (or even just reducing their rate of increase) has often led to increased stress (Figure 13) – even when their level from a strict regulatory perspective has been more than adequate.
Of course, now that the Fed's balance sheet is in rolloff mode, reserves are starting to decline, even if very, very slowly. That's one way reserves will shrink; another way is the upcoming moves in the Treasury General Account at the Fed. King looks at both below:
There are two main drivers of excess reserves, and – while it is conceivable that near-term worries are overdone – both are set to tighten in coming months.
The most obvious – and gradual – is the Fed’s balance sheet reduction. Just as QE led to a $2tn expansion in excess reserves, so as the Fed’s securities holdings are allowed to roll off and its balance sheet contracts, so banks’ excess reserves are contracting in direct proportion. In 18Q1 the contraction has been $20bn/month; from April the pace steps up to $30bn/month, with two more $10bn increments scheduled from June and September.
The second factor is the level of the Treasury General Account (TGA) at the Fed. This – finally – is where T-bill issuance comes in, not through the weight of supply on RV between short-term market rates but through its indirect impact on banks’ excess reserves. When Treasury issuance increases – either through bills or bonds – Treasury either spends the money immediately or deposits it at the Fed. If they spend it immediately – on social security, or infrastructure, or anything else – the level of private sector deposits in the banking system remains unchanged. Even though private sector funds will have been used to buy the Treasury issuance – thereby reducing deposits – Treasury’s spending will sooner or later lead to the same amount being re-deposited in the banking system. The asset which corresponds to the banks’ deposit liabilities is the level of their reserves at the Fed – which will therefore also remain unchanged.
If instead Treasury’s spending is deferred, deposit liabilities in the banking system fall as someone buys the issuance and are instead transferred to the Treasury General Account at the Fed. Once again, the banks’ asset which falls in parallel with their deposit liabilities is the level of reserves.
This relationship explains why there has been a close link between movements in the TGA and movements in banks’ reserves in recent years (Figure 14), with reserves moving roughly $2 for every $1 change in the TGA . This is because there have been other changes in the liability side of the Fed balance sheet besides TGA, such as an increased RRP facility, expanded deposit programs for CCPs, and a natural increase in paper cash, as well as the Fed normalization in recent months.
So why is this macro-level accounting lesson important? Because it has a direct consequence on the cross-currency basis: the one aspect of the liquidity tightening story that has so far not been observed even as Libor-OIS was shot wider. Specifically, the level of reserves has been a direct determinant of stress in money markets – the cross-currency basis in particular. As a rule of thumb, a $200bn reduction in reserves has added about 10bp to the 5y €/$ basis (Figure 15). And as Citi adds, moves in the $/¥ basis have if anything been larger still.
Next, King explains why as a result of seasonal affects, especially as it relates to the tax-collection cycle, the recent surge in Bills has not been sufficient to boost the TGA, and reduce reserves. We will spare readers the details, suffice to note that according to King, should the recent increase in Bill issuance persist, by June banks’ reserves could have fallen by around $300bn.
If realized, this would warrant renewed widening in the cross-currency basis, and would almost certainly stoke the general degree of anxiety about a sharp tightening of $ liquidity.
One possible counter here is that in order to avoid a funding squeeze the Fed could inject extra liquidity, however as we explained last week, this is unlikely, at least until there is a pronounced hit to risk assets at which point the Fed will have no choice but to intervene.
Until then, Citi expects conditions to tighten before anything is implemented, most likely in 2019. As for the Fed, King believes that it seems unlikely they will suddenly spring into action now when they studiously ignored the speeches from the BIS and other central banks when the cross-currency basis gapped out in 2016.
So what happens next?
Well, if the predicted tightening does occur as expected, Citi anticipates three quite far-reaching effects.
First, the foreign bid for $ credit – which has all but evaporated in the past couple of months – will come under greater pressure still.
Optimists may hope that we are simply seeing traditional seasonal weakness, and that once Japanese fiscal year-end
has passed, the pace of buying will pick up again (Figure 16). But to us this seems unlikely. The main driver of Japanese and other foreign investors’ hedge costs is not the cross-currency basis, but the difference in short rates. Even if current Libor and basis pressures were to subside rather than to increase, further Fed rate hikes seem likely to drive hedge costs up – in the case of Japanese investors, from around 2.5% now to over 3% by year end (Figure 17). This consumes almost all of the yield on all but the lowest quality $ investments.
This is something we touched upon two weeks ago when we said that "the rise in dollar funding costs will damage the profitability of hedged investing and lending by foreign financial institutions."
Second, and this is directly a continuation of what we said last week, the rise in $ money market rates would represent a tightening of financial conditions beyond that intended by the Fed.
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.
Citi's third and final point why analysts ignore the blowout in L-OIS at their expense, is that in addition to all these if not anticipated, then at least foreseeable, consequences of tighter $ liquidity, there are quite likely to be additional unanticipated consequences as well.
For example, as shown in the stunning chart below (left side) LIBOR-OIS has in recent years been a very good leading indicator for DXY, with higher spreads leading to a stronger dollar with a 3-month lag (Figure 18). Of course, it is worth noting that $ weakness has been a major contributor to the risk-on environment over the past year (Figure 19) – through its association with stronger emerging markets, through EMFX reserve accumulation contributing to easier global money supply, through its optical contribution to earnings growth at US and global corporates, and through stronger commodity prices.
In other words, if there is indeed a linkage between Libor-OIS and the DXY, then expect a massive spike in the dollar in coming weeks, which in turn would roil risk assets.
In conclusion, King notes that while as a bank Citi is still forecasting a weaker dollar on "fundamental grounds – together with almost everyone else", if the upcoming funding shortage and dollar liquidity tightening does lead to a stronger dollar, "all of these processes have the ability in principle to run in reverse."
Translation: the blow out in Libor-OIS not only matters, but could have very direct - and dire - consequence on equities in the coming weeks.