A week ago, we suggested the dollar funding squeeze was about to get worse.
And it did. Sort of.
Bear with us for a second, and we’ll make this as painless as possible considering the subject matter which isn’t exactly the stuff page-turners are made of.
In a November 22 post, we reminded everyone that the “year-end” funding squeeze showed up at the end of the third quarter when, late in September, the 3-month EURUSD X-Ccy basis fell 25bps in a single session, the largest one-day move since 2009. The same dynamic was visible in the 3-month JPY basis.
Obviously, that was down to the 3-month tenor capturing year-end and by many accounts, dollar funding pressures were expected to worsen thanks to, among other things, the new regulatory regime which incentivizes dollar hoarding on Wall Street.
“We attribute the largest increase in USD funding pressures to dealer and bank balance sheet constraints stemming from key year-end regulatory reporting snapshots, the most relevant amongst these is the GSIB surcharge”, BofAML’s Mark Cabana wrote, in a November 9 note.
You can read more in the post linked above, but suffice to say an interesting juxtaposition is playing out in different measures of dollar funding pressure.
First of all, the cross currency basis has come back in – in a big way. In fact, we’ve retraced the entirety of the September widening in the EUR basis swap and are well on the way in JPY.
That is hardly consistent with a worsening dollar funding squeeze. “This is very unusual as in recent years this seasonal lasted through just before year-end”, BofAML wrote on Wednesday evening, adding that “anecdotally this year’s reversal is due at least in part to investors and banks having prepared for and secured year-end funding at an earlier stage this year in order to avoid last year’s struggles.”
So, “anecdotally”, we’re to believe the signal being sent by cross-currency basis swaps (less demand for dollars) is due to careful planning and better preparedness as everybody remembers how bad things got last year.
Needless to say, that’s not an excuse that’s going to cut it for the inquisitive-minded and to the extent it would have floated yesterday, it most assuredly won’t float now, because on Thursday, Libor jumped the most since March, fixing 3.2bps higher to 2.7381%. That prompted Libor-OIS to widen out to 36bp.
Long story short, that isn’t in any way consistent with the cross currency basis retracing and it doesn’t sound like anybody has any good answers for the time being. Bloomberg’s Cameron Crise covered this all day and if you can’t access the two short missives he penned on Thursday, that’s ok, because this tweet pretty much captures it:
Boy, if there's a good explanation for why x-ccy basis is screaming tighter while FRA/OIS is widening like a banshee, I'd love to hear it. (And no, "LIBOR higher" doesn't cut it, because 3m FX forward points in EUR and JPY are actually narrowing, implying lower $ funding cost)
— Cameron Crise (@5thrule) November 29, 2018
In any event, one assumes there will be no shortage of efforts to explain this over the next couple of weeks, especially considering how concerned everyone is about the prospect of a worsening dollar liquidity squeeze into year-end. That is, if you were already concerned, now something seems “awry” or otherwise fishy – so you probably don’t take much solace in the fact that one indicator is saying something different than the rest.
Meanwhile, Credit Suisse’s Zoltan Pozsar is out with a characteristically opaque “morbidity review” that seeks to review all of the drivers for the outsized move in Libor-OIS from earlier this year on the way to drawing conclusions about how far the recent widening could ultimately run (spoiler alert, Pozsar says 50bps is the limit).
“Views about what drove the Libor-OIS move earlier this year have become dogmatic and letting dogmatism get in the way of pragmatism may come at the cost of future returns”, Pozsar chides, on the way to noting that while increased bill supply and repatriation are the two most oft-cited factors, that doesn’t tell the whole story. To wit, from a note dated Tuesday:
In retrospect, we count six distinct drivers of the Libor-OIS move. In chronological order these are: U.S. banks’ G-SIB surcharges, repatriation, and bill supply in primary markets, and the equity market selloff of mid-February, Japanese fiscal year-end rebalancing, and the resulting increase in broker-dealers’ IG credit inventories in secondary markets. Several of these drivers are “live” again, driving the Libor move that started in October.
There’s more on the GSIB surcharges in the linked post above and you can read more than you’d ever want to know about it in Pozsar’s full note, but in the interest of making good on our initial promise to keep this relatively painless, we’ll just excerpt the broad strokes bullet points from Zoltan’s executive summary and leave it at that.
- Libor-OIS is widening again, up by close to 20 bps since October. It can widen another 20 bps at most until it gets to 50 bps, at which point crossover investors– intermediate and unconstrained bond funds – should provide a backstop bid.
- But there are three caveats to this forecast, all of which have to do with the stock market…
- First, a market selloff can weaken demand for CD and CP from seclenders’ cash collateral reinvestment accounts, which can pressure Libor-OIS wider.
- Second, a stock market selloff can also prompt cash-rich corporate treasurers to sell front-end bank debt from their offshore investment portfolios, which, in turn, could pressure higher the spreads at which the backstop bid is triggered.
- Third, given how large the flows generated by the sales of corporate treasurers, a backup in dealers’ IG inventories can lead to a deterioration of LCR metrics, which would have to be remedied through CD and CP issuance into year-end – these prints can push Libor-OIS wider, as it they did around March 31, 2018. If stocks post a massive rally before year-end, then the opposite would happen – risks to our call for Libor-OIS to peak at 50 bps would be to the downside.
- Our forecast is derived from a careful analysis of the big Libor-OIS move of 2017-18. Part one of our analysis, provides a “morbidity review” of that move, analyzing all the primary and secondary market drivers that contributed to it.
- One lesson from part one of our analysis is that STIR traders and strategists focus too much on markets that are adjacent to the three-month Libor point – such as bills, repo, FX forwards – and the term structure of the Libor curve, to the neglect of stock market dynamics and the dynamics of the IG market.
- Part two of our analysis, provides an analysis of who backstops Libor-OIS moves and at what spreads. Here, we find that post-corporate tax reform, intermediate bond funds are the backstop bid for bigger Libor-OIS dislocations. Because intermediate bond funds typically invest at the 2-3 year segment of the IG credit curve, they would only backstop Libor-OIS dislocations if spreads at the tree-month point get flat relative to spreads at the 2-3 year segment. As such, the slope of the IG curve relative to the three-month Libor point is what ultimately determines how wide Libor-OIS can go during an episode of stress.