Why is LIBOR Moving Higher?

Indeed, volatility is back. BTD may not be dead, and as I have mentioned here, I’m not convinced the bull market is dead and spoos are heading back to 2000 (yet). However, the systematic gamma sellers have taken a serious beating--and one that doesn’t seem to want to let up.   

Beyond a couple of bullet point sized comments, I’ll again leave it to the peanut gallery to advance the discussion on where markets are going in the next couple of weeks. My take on the steel tariff move by Trump is that it is not a game changer for the economy at large but was designed by the administration’s trade negotiators as a tactic to make them look more serious in negotiations with China and NAFTA.  

A lot of people ask me, “As a bond trader, what do you do?”  Well ok, I guess nobody has ever asked me that. If fact, I find that most friends and family are pretty happy to not know what I do at all.  But in the US fixed income world, one of the big asset classes is LIBOR spreads.

These trades can take on all kinds of forms, where you can bet on (or hedge) the spread between LIBOR and OIS, LIBOR and Treasury rates, or the individual components of LIBOR (1mo vs. 3mo, or 3mo vs. 6mo fixings, etc.). The people looking to hedge are often banks with various tenors of floating loans they want to match up, or asset managers that want to switch their liabilities from one benchmark (say, LIBOR) to another (like OIS).

Theoretically, LIBOR rates are the rate at which banks lend to each other, but nobody really does that any more. Today this rate is often set by bankers with an algorithm that takes into account various credit-driven short-term funding markets like repo, commercial paper and cross currency swaps. When credit tightens up, bank balance sheets contract, and/or capital leaves the market at large, these rates move higher relative to OIS, which is and overnight rate indexed to the fed funds rate that is more or less controlled by FOMC policy.   

If the market is really scared--to the point where there is some question about the viability of the banks that are holding all of this credit risk and collateral for clients, LIBOR blows out to extreme levels. This is what happened in 2008-2009 and 2011-2012 during the GFC and European sovereign debt crisis. More prosaic spread widenings have occurred recently around the taper tantrum, China deval in 2015 and early 2016, and Brexit in 2016.

By contrast, these spreads contract when the market believes there will be more money to lend, which drives down interest rates. This is exactly what happened after Trump’s victory in the US election. After years or tightening balance sheets in reaction to Dodd-Frank regulations and a variety of Basel II reforms designed to increase bank capital, banks had less free capital to lend. When Trump won, his pronouncements about cutting regulations were seen as freeing up capital for banks to start lending again.

“Risk on” and tightening credit spreads didn’t hurt either. In mid-2017, the spot 3mo LIBOR/OIS spread went from the mid-30s to the teens, while forward spreads fell by 10-15bps too.

(Source: JP Morgan data; note: I used a 5-day MVA here to make the chart less noisy)

This trend reversed in style starting in December, when LIBOR fixings started to trend higher, taking all of the forward basis levels up with it. What happened?

The answer lies in deep in the plumbing of the financial system. Back in December, two big things happened to impact short term funding markets:

1. Trump and congress passed the tax reform bill. This gave many corporations with dollar assets offshore the incentive to repatriate those dollars and use them for share buybacks, dividends or M&A. The loss of that supply of dollars to lend out caused lending rates to increase,
2. In the same tax reform, and in the subsequent budget deal with Democrats, the US decided to borrow more money. A lot more money. This will cause a big increase in t-bill supply, which will have the end effect of crowding out private borrowing--or at least causing the demand curve to shift to the right, also leading to higher borrowing rates.  

For most of 2017, 3mo t-bill rates had been stable around 10bps tighter than OIS. Since the budget deal, that spread has moved 10-12bps wider. LIBOR has moved even wider, essentially taking in the impact of both the t-bill supply and the corporate foreign earnings repatriation.

We’ve seen the impact in commercial paper and repo rates as well:

(Source: JP Morgan data)

We’ve seen cross currency basis (the deviation between covered interest rate parity and where one can borrow or lend in USD in currency forward markets) has tightened as well, although not dramatically. The sum impact of these factors means LIBOR fixings are moving higher not because of any stress to the banking system, but because there is a greater shortage of USD funding, and fears of greater supply are forcing treasuries to cheapen.

In the end, I see the funding factor (offshore profit repatriation) and the supply factor (more t-bills) each having widened short-term funding rates by roughly 10bps--other measures that indicate pure (or more pure, anyway) expressions of bank credit risk (like 3mo/6mo LIBOR basis) are showing very little movement, despite the pullback in equity markets the past few weeks. That tells me this move is all about USD supply and t-bill issuance.

Where do these markets go from here? Here is a cleaner look at the LIBOR/ois forward markets relative to “spot”:

Put another way, the market is pricing a significant tightening in the LIBOR/OIS spread one year forward. 1y1y LIBOR/OIS is trading 5-8bps higher than it was for most of 2017. (Note also here that the market was set up for part of this move--presumably the offshore profits repatriation, but was caught with its pants down in the budget deal.)  That order of magnitude looks about right to me--clearly hedge funds stepped into this trade in size this week. From these levels, I would look to pay forwards 2-3 years out  vs. receiving front-end FRA/OIS (the short-term version of this trade in eurodollars), on the idea that 1) inversions in this curve are very rare, 2) there is no sign of credit stress, and in fact, short-term funding rates could subside soon as the Fed moves to reduce leverage limits for the banks, but 3) the long-term fiscal impact of the t-bill supply will likely be ongoing, and maybe worsen if the economy slows down and/or if credit markets weaken.

If you made it this far, you are either a basis junkie or you win the medal for getting through Professor MacroShawn’s Funding Markets 101 class. Either way, kick back with a Friday afternoon happy hour beverage of your choice. You deserve it.

Have a good weekend!

Shawn
TeamMacroMan2@gmail.com

@EMInflationista