Recent stress in equities has not spilled over significantly into other markets. High yield credit spreads have widened only moderately and 10-year US yields have been relatively stable. One indicator, however, which was closely watched as a measure of bank credit risk during the 2008 crisis, is flashing amber.
The spread between USD LIBOR, the rate at which banks borrow from one another, and the overnight indexed swap (OIS) rate, a measure of the future level of Fed Funds, has increased from 10bps to almost 60bps since November, to reach its widest level since the financial crisis.
But the widening LIBOR-OIS spread is signalling changes in the supply/demand balance and structure of money markets, not a bank liquidity problem:
- Increased Treasury bill supply, and declining excess reserves as the Federal Reserve shrinks its balance sheet, have pushed up short-term borrowing costs relative to Fed Funds.
- Incentives for US companies to repatriate overseas cash and changes to the taxation of inter-company loans are pushing corporates into the commercial paper (CP) market, while 2016’s money market reform made CP less attractive for investors. This has pushed up borrowing costs.
- Other indicators show no stress. The cost of borrowing dollars for other currencies in foreign-exchange swap markets (the cross currency basis swap) has barely moved. US financial conditions remain loose, according to the Chicago Fed’s index.
So, while the price of funding is changing, access to funding isn’t. And the price of funding is rising intentionally; the Fed is gradually raising rates to keep the US economy from overheating.
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