Article / 28 March 2018 at 1:26 GMT

Blowout in LIBOR-OIS spread could give USD the boost it needs

Managing Director / Technical Research Limited
New Zealand
  • The Trump tax package is raising US funding costs
  • The LIBOR-OIS gap has hit its widest since 2011
  • Hedging costs are holding back foreign buying of T bonds

By Max McKegg

The impact of President Trump’s tax reform package is slowly working its way through the system but US money market traders are noticing the effects already. USD traders could be next if history is any guide.

Exhibit number one is the LIBOR-OIS spread, which has blown out to over 50 basis points, as shown in the chart below. The other major markets are relatively unscathed. Let’s have a look at what’s going on here.

LIBOR-OIS majors chart
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Source: Thomson Reuters


We all know what LIBOR is: the benchmark for inter-bank funding rates. Three month USD LIBOR currently sits at 2.30%.

The OIS is the Overnight Index Swap where traders pay the overnight Fed funds rate and receive a fixed rate (or vice versa) for a longer period, say three months. No principal payments change hands, meaning credit risk is low. Contracts get settled on maturity depending on how the overnight and fixed rates moved during the contract period. Like Fed funds futures, the fixed rate side of the OIS is an indicator of where the market expects fed funds to trade in later dates. While credit risk in an OIS is restricted to the net of fixed and floating payments on maturity, in LIBOR deals one party lends funds to another so principal is exposed.

Therefore, in times of stress in the interbank markets, when banks are wary of lending to each other, the spread between the risk-free rate (OIS) and the principal at risk rate (LIBOR) can blow out.

So is that the explanation for the blowout in the LIBOR-OIS spread in recent weeks?

To put things in context, the spread blew out to 350 basis points during the GFC. Today’s 55 basis points is mild in comparison, but nevertheless is at its highest level since 2011.

So something is going on. That something is US branches of foreign banks borrowing on the LIBOR market. They have been forced to do this by a section of the US tax reform package called Base erosion and anti-abuse tax (BEAT), which penalises foreign banks in the US for borrowing dollars from their offshore parents. Repatriation flows spurred by the tax package are also a factor in LIBOR’s rise as are large issuance of bills by the US Treasury as they build up cash balances at the Fed.


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It's different this time ... the blowout in the LIBOR-OIS spread is not due to bank credit risk worries, as it was during the GFC. Photo: Shutterstock


Foreign outfits like the beleaguered Deutsche Bank are particularly effected, as are Japanese banks, which have been expanding their operations in the US aggressively in recent years. Previously headquarters would swap locally sourced EUR or JPY for dollars in the FX forwards market and pass those dollars onto the US operation. But that’s come to a grinding halt.

We can see the impact in the USDJPY cross currency swap market where the basis has narrowed significantly (as has the USDEUR basis). The basis is the extra cost involved – in addition to the rate differential – to access USD in the swap market. It is driven by supply and demand.

 USDJPY basis chart
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Source: Wall Street Journal Daily Shot

Will we see USD react to rise in funding costs illustrated by the blow out in LIBOR-OIS? The chart below suggests that we might.

LIBOR-OIS versus USD chart
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Source: Wall Street Journal Daily Shot

The sharp rise in LIBOR is also having an impact on foreign buying of US Treasuries. Many investors buy treasuries and hedge the FX risk by rolling over three-month FX forwards. But with 3-month LIBOR at 2.30% and the 10-year treasury yielding 2.80%, that leaves a EUR-based investor with a hedged yield of only 50 basis points. Better to stay home and buy bunds.

The deal is slightly more attractive for Japanese based investors – but not as attractive as buying bunds on a hedged basis. Withdrawal of foreign buyers was a factor in the yield in the 10-year bond testing 3% a couple of weeks ago.

However, the “obvious” trade of the year – selling US bonds in anticipation of higher yields – has become frustrating for many. In turn, the failure of yields to rise has, perhaps temporarily, halted the recovery in USD. Traders have turned their attention to the implications of the twin deficits (government budget plus the current account), noting similarities with the period of the early 2000s, as shown in the chart below (click to enlarge)

 USD chart
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Source: Metastock. Create your own charts with SaxoTrader; click here to learn more. 


The blowout in the LIBOR-OIS spread is not due to concerns over bank credit risk, as it was during the GFC. Rather it is a symptom of the US tax reform package. The situation will persist until foreign banks operating in the US adjust to the new reality.

US yield spreads versus Germany and Japan  are already at multi-decade highs and any more pressure on LIBOR could be the straw that breaks the camel’s back, driving up the dollar.

For more on forex, click here.

– Edited by Robert Ryan

Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.


1y
Patto Patto
nicely explained Max. Will be interesting to see what happens to USD funding into month end (and Japan financial year end)

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