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Over the last few weeks a metric for borrowing rates in the U.S. has started to climb, and it has concerned some investors who trade in financial instruments with very short-dated maturities.
A metric that measures the difference between Libor (the London interbank borrowing rate where banks lend to each other unsecured) and the overnight interest rate swap (the rate tracking the interest rate set by the central bank) has shot up to more than 50 basis points. Known as the Libor-OIS, it's now at the widest it has been since the euro zone sovereign debt crisis of 2012. It widened more than 15 basis points in the last month alone.
A widening of Libor-OIS is typically associated with heightened credit concerns, however this time analysts are pointing to several structural shifts in money markets (markets that trade in securities with short-dated maturities) rather than banking concerns — as banks are now flooded with liquidity and are generally performing better.
Analysts at Bank of America Merrill Lynch (BAML) have pointed to four factors that are contributing to this rise:
1. An increase in Treasury bill issuance this year with the administration's spending plans. BAML analysts have calculated that the amount of supply (how much the U.S. government borrows) over the past five weeks has exceeded the net bill supply in 2017 by over two times. The extra supply is also beginning to impact demand for Treasury bill auctions. Last week's four-week bill auction saw the second lowest bid-to-cover ratio since 2009.
2. Repatriation effects are putting pressure on dollar funding (where investors borrow in dollars to buy another currency to take advantage of interest rate differences) as many corporates build their liquidity positions ahead of onshore repatriation following the U.S. administration's tax reform measures. BAML analysts estimate that offshore corporates hold about 14 percent of their investments (or $87 billion) worth in money-market paper.
3. Defensive positioning. Many onshore and offshore money market funds have become more defensive in terms of shorter-weighted average maturities (WAM). This means that these funds have been buying bonds with shorter maturities, one-month bonds instead of three-months. And this is due to the unlikely timing of repatriation outflows as well as in anticipation of a rate hike out of the Federal Reserve this week.
4. The Fed's balance sheet unwind is also tightening funding due to excess reserves draining.
As such, most investors expect this Libor-OIS spread to remain wide for the time being.
One of the initial effects is that the transmission of Fed rate hikes is becoming more pronounced via a higher passthrough to borrowers as most mortgage/borrowing metrics are linked to Libor. If the spread continues to widen, the Fed may have to start eyeing these money market developments more closely.
One other implication is that of the attractiveness of the dollar as a funding currency. The move higher in Libor has meant both hedging and funding costs have become more expensive.
Morgan Stanley's Hans Redeker thinks there are reasons to believe this could exert pressure both ways on the dollar going forwards.
Foreign holders of U.S. assets in surplus areas such as Japan and Norway may be incentivized to cut holdings of U.S. Treasurys with both higher rates and higher hedging costs. This would be dollar negative.
However, other investors who have used the dollar to fund investments in higher-yielding alternatives (such as emerging markets) may also be incentivized to cut these positions as well.
Morgan Stanley thinks this is one reason the dollar has appreciated versus emerging markets. Its conclusion is that the dollar may be ripe for a corrective upside rally.
In the last few days, traders have noted that swap spreads (which involves the exchange of interest rates between two parties) have struggled to widen despite the continued move in Libor, which suggests some stabilization. However, Libor tends to underperform after a rate hike and the Fed is widely expected to hike again this Wednesday. April also tends to see seasonally high issuance of Treasury bills, post-tax receipts, therefore we could see more pressure on Libor-OIS in coming months as well.