I’m sure you’ve heard by now, front end rates are on the rise. Not only because the Fed is hiking rates though. LIBOR (the rate that foreign banks pay to borrow 3-month money) has risen over 30 basis points in the past six weeks relative to base rates (known as the LIBOR/OIS spread). What you may not have heard is that the “spread” the US Government pays to borrow funds has also risen 15 basis points in the past six weeks (this is known in the dark corners of the money market as the Treasury/OIS spread). These two entities could not be any different from a credit point of view yet their cost of borrowing has risen nearly in lock step together (Figure 1). Why?
It turns out that each spread has its own reason for widening, but at the core of each are two common themes: Fed balance sheet normalization and financial regulation.
The generally accepted narrative in the market is that Fed balance sheet expansion created $4tn of excess reserves that do nothing but sit on commercial bank balance sheets and earn the overnight rate paid to banks by the Fed (known as IOER, interest on excess reserves). This gets referred to as excess liquidity in the system. This is a very sloppy characterization in my opinion. In reality, these reserves get traded around the system investing in all sorts of various overnight money market products on a daily basis. It is this trading that enables rates like LIBOR, Repo and Treasury/OIS to stay in a somewhat tight range. If banks were able to lever these reserves as they have in the past they would be able to create enough money to satiate the demand for front end borrowing and keep these various spreads in line. Unfortunately, this is not how it works. In order for banks to lever up to invest in LIBOR, Repo, or even treasuries they have to set aside capital. In this environment, capital has a high cost, which caps banks’ ability to absorb changes in spreads. This makes these front end markets very sensitive to changes in supply and demand.
I would argue that the true place to look for excess liquidity in the system is the Fed’s Overnight Reverse Repo facility. This is a facility put in place by the Fed to keep excess money market funds from driving rates below the lower band of the Fed Fund’s target. It is meant to be a last resort for money funds as it pays the lowest rate available to money market investors. As competing rates rise, the amount of money in this facility should fall. This is exactly what has happened so far this year (Figure 2).
Wow, that’s quite a big drop. This graph suggests that there is only $5bn dollars of excess liquidity in the system.
So, where has it all gone?
Putting it all together, the market has had to digest a $320bn increase in front end T-Bill supply in addition to a liquidity drain of $160bn from the Treasury Department. This rush of supply in addition to the banking sector’s inability to lever has caused treasuries to cheapen.
What about LIBOR?
In 2016 there was a major reform that went through money markets. In order for prime money funds to carry non government securities (products tied to LIBOR mainly), they would be required to have a floating price. This resulted in a large shift away from prime money funds toward government money market funds. The magnitude of this shift can be seen in Figure 3. This removed the natural buyer of foreign bank time deposits and commercial paper (the rates upon which LIBOR is based) from the market.
Luckily for foreign banks, there happened to be a dedicated pool of US Dollars sitting idle in overseas securities accounts in need of paper to invest in. This pool of money was in the form of accumulated offshore profits of US Corporations. Foreign banks were able to replace their commercial paper funding with front end corporate issuance. The US Corporations gladly purchased this paper in addition to any other high quality front end paper they found appropriate.
Then corporate tax reform came along. This will require US Corporations to repatriate all of these excess profits held in overseas accounts. As a result, foreign banks can no longer depend on US Corporates to purchase their term debt. They have to return to the short term markets. As seen above, prime funds are no longer there to purchase this short term debt (Figure 3). This has left foreign banks tapping the 3 month commercial paper market without a backstop buyer. As a result, each additional unit of borrowing has caused LIBOR to step wider. The market continues to search for the backstop bid.
Why should we care about this?
All markets are connected, and the money markets represent the tip of the spear. Any large reallocation of liquidity has to impact other markets around it. Look no further than the price action in investment grade credit spreads since this started. I believe this price action is indicative of what’s to come as the Fed unwinds their balance sheet. Most importantly, this sort of price action represents a tightening of financial conditions. As I have shown above, the excess liquidity is gone. The necessary liquidity hasn’t started to go (bank reserves, Figure 4), but it will soon. As this liquidity is removed, prices will have to adjust. Keep an eye on reserves.