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!!

liboreurbortibor

(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.

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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.

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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.

euriugh

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.

tibor

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