A number of strategists wrote last week on the tightening of the LIBOR-OIS spread, the difference between the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate, which normally indicates falling risk in money market securities. Bank of America Merrill Lynch, in a piece entitled, "LIBOR-OIS has rapidly tightened," explains, "The 3-month LIBOR-OIS spread has sharply tightened by over 22bp since early-February to levels last seen since prior to the Fed's December 2015 rate hike.... The recent narrowing is due to a reduced supply of 3m unsecured funding, stabilization in investor demand, and underlying issues with LIBOR." We excerpt from BofA Merrill's piece, as well as briefs from Citi and J.P. Morgan Securities below.
BofA's Mark Cabana writes, "We expect the tightening in 3M LIBOR-OIS should soon stabilize and remain at relatively tight levels. However, the balance of risks is likely skewed for further near-term tightening especially should expectations for a June hike continue to solidify. Catalysts to reverse the recent tightening could come through international tax reform that results in a repatriation of offshore USD holdings or any type of geopolitical risk. The Fed's balance sheet reduction should also increase demand for USD funding, though this would likely follow increases in Treasury supply and higher fed funds prints."
Regarding "Drivers of 3m LIBOR-OIS narrowing," he says, "Three-month LIBOR-OIS has narrowed due to a relative supply/demand imbalance for wholesale funding at the US front end, especially amid relatively limited fixed-rate CP issuance. This imbalance has caused a compression of 90 day AA financial commercial paper rates to OIS and a tightening of spreads on longer-dated floating rate issuance.... This narrowing is attributable to a reduction in short-dated front-end supply, stabilization in investor demand, and exacerbated by only a small number of transactions used to comprise LIBOR submissions."
Citi, in a new "Short-End Notes," writes, "We need to talk about LIBOR." They tell us, "The 3M LIBOR basis (against fed funds OIS and 1M LIBOR) continued to compress this week, going all the way back to the lowest point since the first rate hike in 2015. We are close to the floor for the basis, in our view. However, we don't see clear widening catalysts ahead and expect range-bound LIBOR basis in the near-term. We have a widening bias for Q4 2017."
Their piece explains, "Therefore, the funding needs for the 3M sector for banks is driven by actual funding needs [rather] than arbitrage. However, the funding needs at the 3M tenor have been reduced, due to the number of factors noted below. 1. MMF Reform: The money market reform in October 2016 took $1tn of liquidity away that was available for the CD/CP/TD market, which was a large funding vehicle for the foreign banks.... This caused 3M LIBOR-OIS to exceed over 40bp going into the reform. After the reform, unsecured short-term bank issuance dropped (Foreign bank's CP issuance dropped 20% Y/Y), as they found other sources of funding, causing the basis to drop."
It continues, "2. Regulation: Liquidity Coverage Requirements (LCR) requires banks to hold High Quality Liquid Assets against liabilities maturing under 30 days. Net Stable Funding Ratio (NSFR) requires banks to fund risky assets with [over] 1Y safe liabilities. G-SIB capital surcharges penalize short-term funding for larger banks.... All of these hallowed out wholesale unsecured debt issuance by banks over the years. 3. Excess liquidity: A large increase in the quantity of reserves in the banking system resulted less need for interbank lending/borrowing."
Other factors include: "4. Deleveraging: More recently, we have been seeing foreign banks cutting their dollar lending books, reducing the need for the borrowing. 5. Less credit risk: Post French election, we have been seeing reduction of perceived credit risk of European LIBOR banks, which tend to translate to lower premium for LIBOR."
Citi adds, "As these factors weighed on 3M LIBOR, the continued Fed hike worked as a catalyst for LIBOR-OIS tightening, in our view. We don't expect material change in these fundamentals in the near term ... which would imply lagging of LIBOR vs OIS. The important question now is, how low they can go and what are the catalysts to look out going forward."
Finally, J.P. Morgan Securities writes in their "Short Duration Strategy Weekly <b:>`_," "Two discussions competed for attention in the US money markets this past week. The first was the continuing tightening between Libor and Fed funds. The second was Moody's ratings downgrade of several Canadian banks. As it turns out, the two are not entirely unrelated."
They explain, "We'll address Libor-OIS first. In both 3m and 6m tenors, Libor levels have been remarkably sticky, not rising as quickly as equivalent term OIS, either in the spot market (3m ICE Libor less 3m OIS) or forward space (June 17 IMM FRA-OIS).... In both markets we believe the contraction to multi-year tights is a reflection of improved credit and liquidity conditions following last year's MMF reforms. Additionally, in the swap markets, we think positioning has played a magnifying role."
The piece adds, "Breaking it down into its parts, we've previously noted that Libor levels are a function of rate expectations (the average Fed funds effective rate over the tenor) and credit/liquidity premium that reflects the borrowing costs of large international banks active in the USD credit markets. The rate component is reasonably straight forward, it's a reflection of the market's near-term expectations for Fed policy, and can be readily divined from the Fed funds futures or OIS markets."
