Danger, Will Robinson, danger! The US Libor-OIS spread has risen to its highest level since January 2012.
Q1 2012 was the last time that Core PCE Growth YoY (aka, “inflation”) was above 2%.
(Bloomberg) — Short-term borrowing costs in the U.S. have risen to levels unseen since the financial crisis, and recent moves in two closely watched indicators — the London interbank offered rate and its spread with the Overnight Index Swap rate — are causing some consternation. The spread has expanded to its widest level in more than six years, raising questions about whether risks might be brewing within credit markets. While the recent widening may be technical and doesn’t suggest a systemic risk, several factors in funding markets are likely to prevent a “lasting retracement,” according to analysts.
The London interbank offered rate, or Libor, is a benchmark that’s regarded as a gauge of credit market conditions. Every day, various major banks submit to an administrator estimates of what interest rate they would have to pay to borrow in the interbank market, and these are compiled to establish benchmark rates in five different currencies across seven different loan periods. Those benchmarks underpin interest rates on a range of financial instruments and products from student and car loans to mortgages and credit cards.
The Overnight Index Swap rate is calculated from contracts in which investors swap fixed- and floating-rate cash flows. Some of the most commonly used swap rates relate to the Federal Reserve’s main interest-rate target, and those are regarded as proxies for where markets see U.S. central bank policy headed at various points in the future.
It’s regarded as a measure of how expensive or cheap it will be for banks to borrow, as shown by Libor, relative to a risk-free rate, the kind that’s paid by highly rated sovereign borrowers such as the U.S. government. The Libor-OIS spread provides a more complete picture of how the market is viewing credit conditions because it strips out the effects of underlying interest-rate moves, which are in turn affected by factors such as central bank policy, inflation and growth expectations.
4. Why are people worried?
The Libor rate for three-month loans in dollars has climbed to 2.09 percent, a level it hasn’t reached since 2008. Its spread over the OIS rate has also widened quite dramatically following a Congressional deal on the U.S. budget and debt ceiling on Feb. 8. That gap widened from 25 basis points at the end of January to 44 on March 9, the most since 2012, and the speed of the move up is giving some investors pause for thought.
5. What pushed it up?
Several factors. One has to do with the torrent of Treasury bill supply that the government has unleashed since lawmakers last month resolved their impasse over the nation’s borrowing limit. With that crisis passed, the Treasury has been replenishing its cash balance and that has meant a flood of debt sales, particularly of shorter-dated securities. That has driven up borrowing costs not just for Uncle Sam, but also for other borrowers in the short-term market who rely on instruments such as repurchase agreements and commercial paper.
6. So that’s the only reason it’s widening?
No, the tax legislation passed by Congress in December is also playing a role. The new law offers incentives for corporations to bring money back to the U.S. that they had previously stashed overseas. Much of that offshore hoard has tended to be kept in short-term instruments like commercial and bank paper, and a dwindling of those overseas cash piles is likely to mean reduced demand for these products. And that means higher borrowing costs.
7. Anything else?
Yes. The Federal Reserve is shrinking its $4.4 trillion balance sheet, which means there will be less reserves sloshing around in the financial system. As the U.S. central bank pulls back from providing support, banks are going to have to compete more for funding, and that could force short-term rates higher.
8. So where do Libor and the OIS spread go from here?
Since it appears as though investors are already pricing in events that will take place over the next 9 to 18 months, there is a chance that the pace of Libor increases will slow and that we see some retracement of the Libor-OIS spread widening. Nomura fixed income strategist George Goncalves expects some stability in Libor-based spreads after an anticipated rate hike later this month from the Fed. It’s also worth bearing in mind that similar measures for other currencies such as the euro and yen haven’t shown similar signs of stress, suggesting that we are not currently facing a global crunch.