Perhaps because it reflexively takes us back to an unhappier time, there’s a strong sense of disquiet about the rising gap between the dollar Libor rate, at which banks borrow from one another, and the overnight indexed swap (OIS) rate, a gauge of the future Fed Funds.
Having risen 35 basis points over the past six months, this spread, now at 50bp, is about to break through the highest levels recorded during the European peripheral scare of 2011. It has historically been viewed by investors and policymakers alike as a reliable indicator of the health of financial plumbing. But its widening today should not portend the dark spell of the past.
To understand why, it is useful to decompose the Libor-OIS spread into three parts: the Treasury bill (T-bill)-OIS spread, the commercial paper (CP) to T-bill spread, and Libor to CP spread.
At least two-thirds of the move in Libor-OIS has been driven by a widening in the T-bill-OIS spread. Dollar funding for banks is tightening, but not exceptionally so in the context of a rise in yields on government bills, widely considered the risk free rate of the world. T-bill yields have risen particularly sharply since early February, when the US Congress agreed on further fiscal spending. Supply is at play here, not rising credit risk.
The remaining widening in Libor-OIS is explained by the widening in the CP-T-bill spread. Large corporations fund themselves in this CP market, and their funding became dearer to T-bill rates after US money market reform of 2016. This required the pricing of institutional money market funds investing in CP to move to floating Net Asset Value, shrinking the set of investors who held these instruments. As secured T-bill rates have risen since, unsecured CP rates have climbed with a modestly higher beta. This is a new reality of the market microstructure; again, not a credit issue.
Finally, the spread between Libor rates and CP rates is, if anything, tighter than where it has been in previous Fed hiking cycles. In all, Libor is rising in tandem with T-bill and CP rates, not because financial institutions are becoming more wary of one another.
Signs across different asset classes echo this message. Subordinated debt issued by subinvestment grade financial institutions trades close to its strongest level. US equities are up on the year, with financials outperforming. The premium for funding in dollars, as tracked by the cross-currency basis swaps, barely shows a tremor. US financial conditions remain in the loosest quartile of their distribution of the past 10 years.
So, access to funding isn’t changing, the price of funding is. It isn’t the same thing. The price of funding is changing by design; the Fed is raising rates to keep the US economy from overheating. But, reduced access to funding, especially for able borrowers, would constitute tightening by accident, and must induce the Fed to stop dead in their tracks, and potentially to reverse course. We are very likely to find out at the Fed meeting on Wednesday that isn’t the case.
Does the price of funding not matter at all, then? It most certainly does. It can fundamentally alter market trends. But instead of Libor-OIS widening, which is likely a red herring, we need to focus on the right channels to detect signals of a change in the investment opportunity set.
First, watch the hit from yields to floating rate high yield credit and leveraged loans. We estimate floating rate loans to US borrowers at $2.2tn, nearly half of which have been extended to issuers rated below BB-. Our analysis shows that leveraged loan issuers will remain resilient to the next 75-100bp increase in Fed Funds rates, but could see their interest coverage ratios reaching dangerously low levels beyond that.
Second, watch US growth surprises relative to those in the rest of the world. Widening front end rate interest rate differentials will become more meaningful for currency trends if mirrored in growth differentials. It’s worth paying particular attention to the relative economic cycles of US and China. The EM complex, particularly EM currencies, thus far in a Zen-like calm, may begin to show signs of fatigue if China growth softens against a backdrop of higher US rates. Risks become more elevated as we approach US Trade Representative Office’s report on intellectual property rights.
Third, and perhaps most importantly, watch term premium in the US bond markets. Investors have been worried about the impact of higher rates, but US rates volatility itself hasn’t risen yet, and isn’t likely to unless term premium rises. A change here could mean a sell-off in the US bond hits other assets classes harder and quicker.
Much as one must now prepare for the music stopping, it is important not to overreact when history rhymes for unrelated causes. It’s often said in jest that policy is fully equipped to fight the last crisis. Somehow that’s a reassuring thought today.
Bhanu Baweja is the deputy head of macro strategy at UBS Investment Bank
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