My colleague Oliver Brennan digs deeper into recent moves across key money market spreads & concludes that the overall recent widening is not a precursor to a major macro and/or market crunch.
Sudden sharp changes in these spreads have historically been the best signals of imminent capital markets’ distress & should be monitored very closely which we also complement with our Global Financial Trends analysis which particularly focuses on the hard to measure marginal cross border liquidity flows. Neither is the latter sending out any distress flares yet but later this year when FED QT & ECB Taper become more significant this might easily change, although for now the BoJ’s QE continues to overwhelm.
High LOIS spread suggests dollar funding costs are rising. The 3m LIBOR-OIS spread is a barometer of banking sector risk. LIBOR, the interbank rate, carries more counterparty credit risk than OIS, which represents the central bank rate (and where principal is not exchanged, unlike LIBOR borrowing). The spread has widened to almost 45bp, greater than during a squeeze caused by US money market reforms in 2016 and the highest level since 2012. At those times, other barometers of financial stress were also rising: wider cross-currency basis swaps and tightening financial conditions both showed that the increase in dollar funding costs was global. Now, by contrast, basis swaps are broadly unchanged and global financial conditions remain relatively easy. In fact, longer-term basis swaps suggest foreigners’ dollar funding costs are falling: the 5y EUR basis is at its lowest in three years and the 10y GBP basis is positive.
Dollar funding costs are rising in a specific sector for a specific reason. Higher USD LIBOR spreads over OIS mean that offshore banks are paying more to borrow dollars. But the equivalent cost of borrowing in EUR or other currencies is not rising. The supply of overseas dollars is beginning to fall as US firms begin repatriating profits to take advantage of President Trump’s tax cut. These corporate portfolios had provided a low-cost source of dollar borrowing for offshore banks; now that the supply is falling, the cost is rising.
Financial commercial paper yields are climbing. Concurrently, the spread between financial and non-financial commercial paper (CP) is widening. This is a sign of the relative rise in short term dollar borrowing costs for financials and shows that the squeeze is currently restricted to financials. A change in CP demand from non-financials is set to contribute to the widening, likely also causing a rise in financials’ CP supply: non-US bank CP issuance has increased by $24bn this year. Johnson and Johnson, in its January earnings call, said it was earmarking $12bn of repatriated cash to fund current spending and to pay down some borrowing. J&J has the sixth largest overseas cash hoard. If the likes of Apple and Microsoft (with $380bnof overseas dollars) follow suit, the financial/non-financial CP spread will keep widening as non-financial demand falls and financial supply rises. But we can see that financials’ credit risk is not the cause of higher financial CP:– US bank CDS spreads have tightened since February even as LOIS has widened.
Government Bill yields are also rising. Changes in the onshore US market are exacerbating the dollar shortage. We have long warned that the US Treasury would ramp up Bill issuance this year, as it seeks to rebalance the proportions of outstanding debt back to the long-term average. Pre-QE the Bills/Notes ratio was 44%; during QE it fell to 20% as the Treasury took advantage of the Fed as a price-insensitive Notes buyer. But since QT started, the ratio has been rising again. The Treasury has issued almost three times as many Bills as Notes ($40bn vs $13.4bn). This excess supply has driven up Bill yields, and therefore LIBOR funding costs, over the last few weeks. But the Treasury is not the only source of increased supply.
Net Fed supply. The pace of Fed QT has quickened in recent weeks. SOMA Treasury holdings have fallen by $30bn this year, mostly since the end of January. As Treasuries mature at month end, the Fed is allowing around 30% of the balance to roll off, increasing net bond supply and further draining dollar liquidity. A total of $31bn is due to mature at the end of March and at the end of April. However, as US banks should be agnostic whether they hold T-Bills or deposits at the Fed, T-Bill yields should remain close to the risk-free rate. The more notable aspect of this rise is that it shows T-Bills have been in short supply for most of this century (yields were below the OIS rate) and that supply is finally getting close to meeting demand.
Global liquidity remains abundant. As we discussed in Macro Strategy last month, the BoJ is the current backstop to global liquidity. The BoJ’s balance sheet has expanded by over $100bn this year, dwarfing the Fed’s net total Treasury sales of $30bn since QT started. Of course, BoJ liquidity provision is reactive – it buys more or less paper in response to moves in the JGB yield curve – rather than predetermined, so the pace of asset purchases could slow. But the BoJ is unlikely to tighten policy if a funding squeeze were to push global yields higher. In Global Financial Trends we also showed how Japanese banks are most at risk in the event of a rise in funding costs: all the more reason for the BoJ to remain the world’s most dovish central bank.
Rising funding costs could be a risk if the dollar rallies. In contrast to the global financial crisis and the 2014-2016 period, the dollar is declining. This is a release valve: as offshore borrowing costs increase, the total amount of debt due for refinancing by foreign borrowers falls due to the FX effect. But we have highlighted how the Fed’s reaction function, and therefore dollar dynamics, may change following Fed Chairman Jay Powell’s congressional testimony. A rising dollar would exacerbate and potentially spread the funding squeeze beyond offshore bank borrowing costs. The first test for this will be next week’s FOMC rate decision, when the panel will publish its new dot plots.
Repatriation of corporate profits is the ‘new’ ingredient in offshore dollar funding costs. The amount of cash to be repatriated will become clearer in the next round of quarterly earnings reports. But for now the funding squeeze looks to be limited to banks, which probably relied on corporate cash piles for low-cost dollars and are now paying up to replace this source. In any case, global liquidity remains abundant and there are “puts” in place: in addition to BoJ QQE, remember that the schedule for Fed QT sets caps for redemptions, not targets, meaning the pace could be slowed if necessary. So, all in all, the current blip in funding should remain just that.
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