The Anatomy of a LIBOR Panic: New Wides For LIBOR/OIS

Welcome back MM readers--apologies for the unscheduled hiatus last week. I spent a few days enjoying the technological miracles of the US healthcare system. Keen readers may notice I almost never make a call on stocks, stock sectors, or egads….single name stocks--but it is tough for a trader to walk away from a couple of days in and around a hospital without thinking that there is a lot of capital and profit sloshing around in that place.

Since I was disconnected from markets much of last week I’m going to circle back to the widening in LIBOR/OIS spreads that has continued unabated since I wrote about it a few weeks ago. I'm sure this has been to the erm...consternation of more than a few traders like our good friend here:

Actual footage of a macro trader reacting to the latest LIBOR fixings

JPM published this chart showing that the current 3mo libor/ois spread is at its widest post-crisis level.

That’s amazing, given nobody has really noticed outside of this small sector of the fixed income market. Even the 2016 money market reform move made some headlines in the financial media, even if it didn’t penetrate the white hot din of the US election media coverage.

Sure, there have been a few articles in bloomberg and the WSJ that have highlighted the move higher in LIBOR, what might be driving it and what it might mean for the regular Joe. Quite honestly, with a little time away from it, I think the coverage has overcomplicated the issue. What I think the market is missing is that this really is a plain vanilla credit story.

What makes it different is the magnitude of the move, one driven by the confluence of competing supply and demand factors. Yes, there are many factors that are driving this move, but I think they can be simplified into only two or three. The first, and arguably most important, is the US tax reform. This incentivized US corporate treasurers to start repatriating foreign-domiciled assets, much of which was invested in short-term corporate debt.

And yeah, that matters! What I think has been slightly deceptive in the media coverage of this move is that it has been sold as “having nothing to do with credit,” or that credit hasn't been a driver because various other basis trades (3s6s, xccy basis, etc.) aren't moving much. That’s only partially true, especially when you look at this chart:

Put another way, since the beginning of February you’ve lost all of the spread tightening move since June of last year. This chart also highlights that the weakening of markets in general might also be at play here--an overall weakening of credit markets has caused a re-pricing of the entire credit complex...including commercial paper, bank funding and thus LIBOR.

The second factor is commercial paper. Treasurers are pretty smart people--and most of them have a guy that is sitting in front of a bloomberg terminal all day thinking about how he can fund the company’s working capital 5bps cheaper for a few months. When these guys figured out the tax reform was for real and, later--that there would be an acceleration in t-bill supply because of the bipartisan spending agreement struck in early January, those treasurers wasted no time in tapping the market. Commercial paper outstanding accelerated throughout Q4 and picked up at an even faster pace in January. This acted as a sponge for money market cash...

...Which left the market dry as a bone when the US government dramatically accelerated t-bill issuance in February, increasing the amount of bills outstanding from roughly $2trn to $2.2trn.

You can see how these trends impacted the market by looking at this chart:

LIBOR and commercial paper rates underperformed OIS starting in December, but flattened out in January. Similarly, 3m t-bill rates and OIS followed each other very closely until the t-bill issuance accelerated sharply in February.

At that point all bets were off--with CP rates and t-bill rates widening amid weakening credit markets and an decrease in dollar funding supply, LIBOR started to underperform everything, since panel banks saw that issuance concessions were back and weaker panelists probably had to pay up to get deals done.

The rest, as they say, is history.

Where does the market stand now? Pretty nervous, to say the least. 3mo/3mo forward (June fra/ois) blew out to new wides last week, and the 6m3m (Sept fra/ois) is again skulking around the 40 level.  

This seems like the capitulation move here--L/OIS over 50….money market investors are going to look at that and say this is where we can step in, and there is already some evidence this is happening. I continue to believe that the market will stabilize in the low-mid 30s and we’ll see a return of a more normal looking upward sloping term structure. But when? That’s the big question I guess--however you look to structure this trade, it will be worth considering how much carry and resilience it built into the trade.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista