A look into Libor reform and current elevated spreads
Libor-OIS spreads are elevated, indicating cheapness in the funding markets, but we expect them to normalize in the near to medium term.
- Libor-OIS spreads are higher than normal, indicating cheapness in the bank funding markets.
- Higher spreads are an indication of increased credit and liquidity risks in the banking sector. However, the risk-reward profile is attractive. Things are much different than they were during the global financial crisis: this time the solvency of the banking system is not in question.
- The Money Market Mutual Fund Liquidity Facility is currently supporting Libor spreads.
- Eventually, bank liquidity will normalize and Libor spreads will narrow, but we will need continued normalization in the front-end funding markets to get there.
The London Interbank Offered Rate (Libor), the rate at which banks can fund themselves in the short-term, unsecured interbank market, is in the process of being reformed. However, Libor is here for now and its spread levels can offer useful insights into the state of bank funding markets. Below are some frequently asked questions relevant to liquidity investors about Libor during this current period of volatility.
What are your thoughts on Libor reform?
For our thoughts on Libor reform, please refer to our FAQ: “Markets’ transition away from Libor,” published prior to the COVID-19 pandemic. Our analysis has not changed meaningfully.
Do you think that Libor reform will be delayed?
The COVID-19 pandemic has caused market disruption unlike anything we have seen since the global financial crisis (GFC). In our view, there is potential for Libor reform to be delayed, as market participants have been more focused on their positioning than on the progress of Libor reform. However, we at J.P. Morgan Global Liquidity have already prepared for a December 31, 2021 transition and are not changing our approach at this time.
How do you evaluate whether Libor is indicating increased risk in the funding markets?
The best way to evaluate risk in the short-term bank funding markets is to look at the spread between Libor and the overnight index swap rate (Libor-OIS). In the U.S., OIS is a derivative rate that converts the overnight federal funds rate into a term rate; like Libor, it is commonly quoted for one- and three-month terms. When Libor-OIS is wide, bank funding risk is elevated—which can mean that bank credit risk has risen and/or bank liquidity has diminished. When Libor-OIS is narrow, banks can readily access funding in the short-term markets. The spread, not necessarily the level of Libor itself, is what signals the risk level. In fact, Libor was higher throughout 2019 than it is now, but because Libor-OIS was lower, Libor conditions were considered normal.
Is today’s Libor-OIS widening due to credit risk, liquidity risk or both?
In our view, it is due to both. This downturn will undoubtedly cause a deterioration of asset quality on bank balance sheets. However, through reforms implemented over the last decade by various regulatory bodies and government agencies, banks have built up adequate capital to deal with the economic effects of the pandemic. On the other hand, access to short-term bank wholesale funding markets, and therefore short-term funding liquidity, are still in recovery mode. This is different from the widening of Libor-OIS seen during the GFC, when banks were at the epicenter of the turmoil. Back then, while liquidity risk was an issue, the market questioned the solvency of the financial system. Assets on bank balance sheets were declining in value, thereby eating into bank capital. As banks’ credit profiles deteriorated, they had a difficult time funding themselves. This was particularly true after Lehman Brothers declared bankruptcy.
Libor is determined by a survey. Are there tradable securities that can approximate Libor?
Within front-end tradable securities, you can approximate Libor by looking at yields of A-1/P-1 or better- rated bank commercial paper (CP) or certificates of deposit (CD) of the appropriate tenor. While bank CP and CDs are not interbank lending, their yields are observable market data points in the unsecured, short-term fixed income markets. In the absence of robust CP and CD trades, Libor setters may also infer short-term funding costs from other markets, including derivatives and the foreign exchange (FX) markets, which may also be experiencing varying degrees of normalcy–or lack thereof.
Are CP and CDs attractively priced generally?
Yes, we believe so. Libor-OIS is still wide relative to history. At the same time, the Federal Reserve (Fed) is supporting certain segments of the CP and CD market with the Money Market Mutual Fund Liquidity Facility (MMLF) and although banks will face some write-downs on assets as a result of the pandemic, they are otherwise fundamentally well capitalized, in general. Since the normalization process is underway but yet still has room to run, we believe that current yields on front-end fixed income investments issued by high quality banks offer attractive value.
Are there examples of times when Libor-OIS widened but bank credit risk was not deteriorating?
There are two somewhat recent examples. During 2016, nearly a trillion dollars migrated from U.S. prime money market funds (prime funds) to government money market funds due to money market fund reform. As a result, Libor-OIS spreads widened from 23bps in the beginning of the year to 43bps in the fall of 2016. Similarly, in 2018 Libor-OIS widened from 26bps in the beginning of the year to 60bps in the spring when U.S. tax reform spurred U.S. corporations to repatriate their cash. In both of these situations, banks were generally healthy and asset quality was relatively stable. However, cash was migrating away from prime funds, which primarily hold bank CP and CDs. When prime funds are losing assets, banks have less liquidity and front-end yields need to rise to attract other buyers.
Where is three-month Libor-OIS today, vs. its historical average and its peak during the GFC?
As of April 17, 2020, three-month Libor-OIS was 103 basis points (bps). That is considerably wider than its 10-year average from March 2010 to March 2020 of 24bps (based on month end data), but considerably below its peak at 364bps during the GFC (based on daily data).
Which is a better indicator of risk, Libor-OIS or the TED spread?
Both are viable indicators. The TED spread is the spread between three-month Libor and three-month U.S Treasury bill (T-bill) yields. Today, market participants prefer to use Libor-OIS to measure bank funding risk. OIS is a more direct measure of monetary policy while T-bill yields can be subject to supply-demand technical factors in the rates market.
Did bank regulation contribute to the lack of liquidity in money markets?
There are a number of bank regulatory rules that restrict banks’ ability to expand their balance sheets—with good reason. Unfettered balance sheet expansion without adequate capital and liquidity buffers can introduce undue risks and instability into the banking system. In the COVID-19 environment, however, it does appear that some banks believed certain regulations were limiting their ability to trade and take on additional assets, even though it was clear that the market needed more secondary liquidity than was available. The Fed has since helped liquidity recover in money markets by allowing regulatory neutralization on fundings from the MMLF.
What can drive Libor-OIS spreads to narrow from here?
Due to year-to-date net outflows, prime funds, industrywide, are not buying the same amount of term securities as they did prior to the pandemic. As we see more inflows back into the prime space, we expect to see increased buying of term securities, which should drive yields down on three-month to six-month maturity CP and CDs. Once term CP and CD yields come down, Libor should also compress.
Why is it important for Libor-OIS to trade within a more normal range?
Elevated Libor-OIS increases the cost of capital for the financial markets as a whole, not just for banks. In order to benefit more fully from the Fed’s zero interest rate policy (ZIRP), the economy needs to see lower credit yields in general, not just lower U.S. Treasury yields.
Is the MMLF influencing Libor?
Yes, we believe it is. The MMLF gives funding, on a regulatory neutralized basis, to broker dealers who purchase U.S. issued CP and CDs from prime funds1. The funding rate is 1.25% for these purchases. As a result, we have seen three- to six-month maturity CP and CDs eligible for this program trade in an approximate range of 1.00% to 1.50% yield, but yields are compressing. During the height of market disruption in mid- to late-March, the MMLF effectively worked as a cap on yields for these instruments. Without it, clearing levels on CP and CDs around that time would likely have been hundreds of basis points wider. Libor survey results would undoubtedly have been wider as a consequence.
Should the Fed lower the funding rate on the MMLF for CP and CDs?
Our answer is a cautious yes, but we think the rate should be lowered gradually. Now that liquidity has improved in prime funds, the MMLF may be working somewhat as a soft floor on CP and CD yields because some market participants are reluctant to transact too far below the 1.25% MMLF funding rate for longer money market securities. The MMLF is a large-scale funder of CP and CD purchases in the marketplace today, and it is having a sizable influence on these money market instruments’ yields. The Fed could choose to set the MMLF funding rate for CP and CDs at 0.25% and Libor would likely move quickly to that level. That does not mean that the Fed should take such action. The key will be to get to a place where prices are set by end buyers, not by the Fed. In our view, this can be achieved by lowering the funding rate gradually as assets under management in prime funds stabilize and prime funds buy more term CP and CDs.
What do you see as the right amount of funding in the CP and CD markets?
The exact amount remains to be seen, but if the prime fund space is smaller as a result of the pandemic, banks that normally rely on the CP and CD market will have to turn to other funding sources. That could include, but would not be limited to, corporate bonds, covered bonds, asset backed securities (ABS), and retail and commercial deposits. We saw banks diversify funding sources following money market reforms in 2016. We may see banks continue to diversify as a result of the pandemic. Eventually a new equilibrium will be reached, and the CP and CD markets will find market clearing levels without government support. At that point, Libor settings will likely be determined more by natural market forces and information than by Fed action.
If you have further questions about this or other topics, please reach out to your J.P. Morgan Global Liquidity Client Advisor.
1The MMLF may only be used for purchases from prime money market funds of tier 1 CP and CDs issued by U.S. entities and for purchases from municipal money market funds of tier 1 equivalent municipal securities.