By Michael Gladchun, VP, Senior Fixed Income Trader
Traditionally, a widening spread between LIBOR and OIS (LOIS) has been viewed as a sign of emerging stress in the financial system. This spread is now at its widest level since the global financial crisis, exceeding levels seen at the height of the European sovereign debt crisis (2011-2012) and in the midst of US money market reform in late 2016.
Understandably, the sharp widening in LOIS has investors concerned and wondering:
As we will explain, we believe technical factors have driven LOIS wider; we do not consider it a sign of financial stress or a factor likely to alter near-term monetary policy.
Analyzing the data, 3-month LIBOR has increased by more than 60 basis points (bps) year to date through April 9, despite the Federal Open Market Committee (FOMC) having made only one 25-bp increase in the federal funds rate during the same period.
It appears that the majority of the recent rise in 3-month LIBOR has more to do with factors that are unrelated to the expected path for the fed funds rate; consider that the spread between 3-month LIBOR and the market’s expected path for the fed funds rate over the same 3-month term (the 3-month overnight index swap rate, or OIS) has widened by about 35 bps year to date and nearly 50 bps since November 1, 2017.
We believe that the recent widening in LOIS is fully attributable to technical factors that can be easily explained. While we acknowledge that there are structural shifts occurring in the market that are likely to cause LOIS to continue to be more volatile and, on average, probably a bit wider relative to history, we don’t think this is consequential at the macro level. We would caution against inferring much, if any, signal from isolated movements in LOIS. We believe the FOMC likely shares this view and, as such, we foresee no material impact from the recent LOIS widening on the path for the fed funds rate or FOMC communications in the very near term.
So, what do we believe has contributed to the recent widening of LOIS? In seeking to understand and explain the widening, we find it useful to think of LOIS as a spread consisting of three component spreads.
The table below details how and why these component spreads have risen since the LOIS widening trend began in November 2017.
In an effort to further clarify the influence of the components, the chart below shows data normalized to begin at zero on November 1, 2017.
In summary, we think the recent widening in LOIS is about a supply and demand imbalance triggered by a surge in demand for US dollars by money markets (increased T-bill supply, BEAT-related CP issuance) amid a reduction in the supply of funds available (due to US dollar repatriation). The move has likely been exacerbated by the pro-cyclical feedback loop embedded in the LIBOR reporting methodology. We believe these factors represent either short-term technical pressures or an ongoing adjustment in market structure, neither of which we view as a cause for concern regarding the health of the financial system or the general state of broad financial conditions.
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