Kotok: LOIS is Screaming
In this issue of The Institutional Risk Analyst, we feature a comment from our fellow fisherman David Kotok, Chairman & Chief Investment Officer of Cumberland Advisors (www.cumber.com), which was published earlier this week. A number of people have asked about the widening spread between LIBOR and the comparable rate in the US. The short answer is that, yes, it is a structural problem and may be a warning of future contagion ahead. Questions? Join us Thursday at the University of South Florida in Sarasota when we'll be talking about the state of the US banking industry and signing copies of "Ford Men: From Inspiration to Enterprise."
Today we look at the warning that the widening spread between the LIBOR rate and the OIS rate may be sounding about what lies ahead, given a two-pronged Fed tightening policy. Whether investors realize it or not, this spread (LOIS) impacts what strategies make for successful investing. This five-minute read will bring readers up to speed. We will start with Daniel Kurt's Investopedia post, "What is the OIS LIBOR Spread and What Is It For?," from Feb. 21 of this year
(https://www.investopedia.com/articles/active-trading/061114/what-ois-libor-spread-and-what-it.asp): "A decade ago, most traders didn't pay much attention to the difference between two important interest rates, the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. That's because, until 2008, the gap, or 'spread,' between the two was minimal. But when LIBOR briefly skyrocketed in relation to OIS during the financial crisis beginning in 2007, the financial sector took note. Today, the LIBOR-OIS spread is considered a key measure of credit risk within the banking sector. (For a glimpse into the possible evolution of these two rates, read 'Will OIS Replace LIBOR?')"
The LIBOR-OIS spread (or LOIS) has widened by twice the amount that the Federal Reserve has hiked rates. There are reasons for that, and we will discuss them below. But the impact of the LOIS's widening is at hand today. Think of it this way. The Fed sets the OIS as it determines the short-term policy rate. If the Fed wants to tighten policy by raising the short-term rate a quarter point, it has the complete power to do so. But the Fed cannot control those market forces that react to the Fed and to other factors. So if the Fed hikes a quarter point but market forces actually translate that hike into a half point, is the impact of the Fed's quarter point magnified and, in this case, doubled? We think the answer is yes. There are structural reasons why this magnification is occurring, and they are still in play. Hence the Fed is actually tighter than it would appear to be if we look only at the fed funds target rate and, by implication, at OIS. Three-month LOIS increased over a half point in the first quarter of 2018, while the Fed's policy target rate went up only a quarter point. And US Treasury debt management added to this mix. US Treasury bill yields are at their widest levels to OIS in fifteen years. They have widened in spread by a quarter point since the beginning of the year.
At the end of the first quarter, three-month LIBOR was 2.30%. A year ago it was 1.15%. Thus the private sector has seen a 1.15% increase in this key interest rate. Note that about $200 trillion in global debt and derivatives prices daily from LIBOR. FRA (forward rates) used in foreign exchange derivatives are up 1% in the same period. So are US T-bill rates. And the new money market rules exacerbate these spreads. Meanwhile, the TED spread (eurodollar vs. T-bill) is wider than it was a year ago. I could go on, but the key point here is that the system is tighter by more than the Fed has tightened. There are at least six reasons: 1. Banks are reluctant to shift their liquidity pools out of the Fed (source: Joe Abate at Barclays). 2. Congress insists on perpetrating political shenanigans with the federal debt ceiling (BCA Research opinion). 3. Repatriation flows are adjusting cash balances worldwide, and the direct impact falls on the short-term money market end of the yield curve. 4. The Fed is shrinking its balance sheet at the same time it is raising the policy-setting, short-term target rate. (We think this approach is a potential double whammy for the markets. The Fed is playing with fire by trying to do two things at once.) 5. The new "base erosion and anti-abuse tax" (BEAT) was part of the 2017 tax code changes. It is causing dislocation in funding markets and driving some firms to use commercial paper (CP) as a way around the tax problem. But the CP traditional buyer was a money market fund that is now in the non-government group and can "break the buck." Using cross-currency swaps is an alternative, but banks "that used to be sources of structural demand for dollar funding (widening the basis swap) will require less dollar funding in the future. As a result, basis swap spreads tighten" (Deutsche Bank AG/London). 6. LIBOR is being phased out by 2021. The Alternative Reference Rate Committee (ARRC) wants to replace LIBOR with a new Secured Overnight Futures Rate (trading), or SOFR. Some banks are now leaving the LIBOR-setting pool in anticipation. There will be new SOFR futures contracts launched and trading. For the average investor this is a bewildering array of technical factors. We plod through all these factors ourselves in our daily work as we do the analysis on so many moving parts. Most investors have never heard of ARRC or SOFR, yet both impact their daily lives. Our issue concerns the businessmen and women who borrow using LIBOR as a reference rate. Their costs of funds are going up fast. And they are uncertain about future commitments since they know LIBOR is going away and they don't know what the market will do to replace it. And they are the ultimate target of Fed policy, for better or worse. For us there is a different question. We are puzzled by the Fed's silence on these impacts. The dot plots don't capture it. This issue is not about a GDP forecast. We are not talking about higher inflation expectations. No, this is about structural change and its impacts are broad. We worry that the Fed is setting things up for a slowing of the economy by being too doctrinaire and neglecting to acknowledge these structural changes. We worry that QT (quantitative tightening) is a dangerous force to combine with traditional interest rate normalization. We worry that the Fed has undertaken too much and is sailing the monetary policy boat into waters where the charts are incomplete. We think this policy error could be one of the reasons that the yield curve is flattening. At Cumberland our emphasis is on the higher-grade credits, whether muni or corporate or government. We are watching the distribution of credit and note Jim Bianco's observation that about half of the investment-grade debt is now Baa-rated. Jim points out that this percentage has nearly doubled from 25% in 1989. For Cumberland, that means about half the debt aggregate is off the table for our clients. We want to be sure our clients get paid. Bottom line: LOIS is screaming a message of warning. We know that members of the Fed are looking at this, but we wish there were more observations about it in their public statements. We don't expect the Fed to change its strategy. It is on a dual course of QT and rate hiking and will probably stay that course unless and until some shock occurs. So our professional stance is to worry. And we continue to search out and focus on high-grade credits. We think investors are poorly paid for chasing lower-grade or junk.
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