The “Unintended” Consequences of Fed’s Swap Lines (Made It A Little TOO Attractive)

How about them interbank rates? The Fed is dancing with joy!!


(Bloomberg) — The Federal Reserve’s efforts to beef up its swap program may have made it a little too attractive.

While the U.S. benchmark rate at which banks borrow from one another is coming down, its European equivalent — known as Euribor — jumped 2.9 basis points to a fresh four-year high on Thursday. That’s even after the European Central Bank moved to ease funding pressures by moderating collateral restrictions for financial institutions seeking to borrow from the central bank.


It’s a disconnect that’s sprung up in part because the Fed has helped bring down the cost of dollars to such an extent that they’re cheaper to borrow in cross-currency markets than any major currency. Opportunistic players are tapping local markets in Europe to swap into dollars, elevating domestic borrowing costs.

“This is a tightening of financial conditions at a time central banks are trying to keep rates low and credit flowing,” said Antoine Bouvet, head of rates strategy at ING Bank NV. Financial fragmentation across European markets — as shown by the stretched spread between benchmark Italian and German yields — is further complicating the ECB’s efforts, he said.

That dislocation showed signs of easing Thursday on reports that German Chancellor Angela Merkel supports a huge stimulus package for the bloc. Meanwhile, the ECB keeps rolling out new measures, having already pledged to buy more than 1 trillion euros of debt over the rest of this year, scrapped most of its limits on which markets it can target, and decided to accept junk-rated debt as collateral for its lending program to help businesses.

Analysts see its latest steps to ease funding pressures ultimately helping. “It provides a backstop for the market not to be concerned about bank funding issues related to a shrinking collateral pool in case of rating downgrades,” Frederik Ducrozet, strategist at Banque Pictet & Cie in Geneva, wrote in a note.

Early signs in the futures market suggest Euribor will get a reprieve within the next couple of months.

And as dollar Libor’s spread over swaps tightens — as indicated by futures markets — three-month cross-currency basis should drift lower to erode the funding advantage for local currencies, and reduce the incentive for opportunists to bid up the cost of funds in domestic markets.

Three-month dollar Libor fell 2.9 basis points on Thursday to below 1% for the first time in more than a month, driving its premium above overnight index swaps — a proxy for the risk-free rate — lower by a similar amount.

Some traders have even begun to hedge against negative Libor rates, using the Eurodollar options market.


Sub-zero rates are already a reality in Japan, where the three-month euro-yen Tibor fixing dropped 6.6 basis points to -0.048%, posting a negative fix for the first time ever. Euroyen futures popped higher in response.

With yen-OIS rates steady, the move seemed unrelated to policy expectations. Instead, overseas banks could be in the driving seat; the domestically-focused Tibor fixing was unchanged on the day.


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