Graphic Content – March; why LIBOR suggests a US dollar rally
23rd March 2018
Making the headlines recently has been the widening of LIBOR/OIS spreads in the USD market (sometimes also called FRA/OIS spreads, or even other variations). But what exactly is this, and why does it matter? Should we be concerned?
In simple terms: banks interact with the Federal Reserve at the Fed Funds Rate, while they lend and borrow from each other at LIBOR. That is why, then, so many real-world products are directly linked to LIBOR – mortgages, for example.
So when the LIBOR/OIS spread widens, financial markets are tightening more than that implied by market hikes. Why is this happening?
Firstly, the Fed’s balance sheet reduction is draining liquidity out of the system, and has a knock-on effect. But this has been in process for some time, and does not explain the sharp recent moves.
Instead, we look at large (both actual and anticipated) T-Bill issuance by the US Treasury since the debt ceiling was raised. As T-Bill yields have risen, US Money Market Funds have diverted their cash into these instruments, away from banks. International banks in particular rely heavily on these, and short-term borrowing costs have risen sharply for such banks – leading to a surge in LIBOR.
While this increased the cost of borrowing US Dollars, it has not yet been exacerbated by a widening in cross-currency basis, which would make US Dollar borrowing via FX swaps even more expensive, largely, we believe, due to international hedging flows on the back of increased corporate issuance. But this could change very quickly.
To summarise: the widening in LIBOR/OIS has occurred primarily for technical reasons – rather than being a sign of stress. However, the increased funding costs due to this widening could themselves cause stress, especially if we see a widening of the cross-currency basis.
One potential consequence of this is a strengthening of the USD itself. A USD funding squeeze, combined with the current record short positioning, could see a large reversal higher in the USD, as this chart suggests:
LIBOR/OIS Spreads compared to the US Dollar Index 2016 to 2018