Meet LOIS and Hear What She Has to Say
LOIS is a bit of a complicated construct. The “L” is extracted from the London Interbank Offered Rate (LIBOR), the rate at which banks lend to one another and for which counterparty risk is a consideration. “OIS”, the Overnight Indexed Swap rate, captures the market’s expectation for the path of the Federal Funds rate, but it does so with very limited counterparty risk and without the actual transfer of cash. The difference between the two, often referred to as LOIS, therefore reflects both available liquidity and banks’ perceptions of the credit worthiness of their peers.
In short, LOIS provides valuable insight into the health of the banking system. A widening in the spread is often an indication of mounting stress in credit markets, which is why we are writing about it today.
Over the past four months, LOIS has widened about 50 basis points (bps) to the widest spread observed since the Great Financial Crisis. So, are funding markets flashing red? We don’t think so.
LIBOR – OIS Spread
Source: Thomson Reuters Datastream NYLIM 3/28/18. LIBOR stands for the London Interbank Offered rate and represents three-month LIBOR in USD, while the OIS stands for the three-month overnight indexed swap rate.
Take It with A Grain of Salt
Outside of the short-term funding market, there are few signs (if any) of mounting strain within credit:
- Bank credit default swap pricing has not moved materially higher
- Spreads on corporate bonds of various quality ratings remain tight
- Default rates are exceptionally low
Additionally, money supply (M2) is growing (as of March 12), and commercial and industrial bank lending continues to expand healthily (as of March 14).1
If It Is Not about Credit Concerns, Then It Must Be About Liquidity
We see at least two sources of disruption to the supply/demand balance for money market instruments:
- Tax reform legislation aimed to encourage corporations to repatriate a few trillion dollars in retained earnings held abroad. That cash, while held in foreign custody accounts, was generally invested in short term, dollar-denominated instruments that are now being liquidated.
- The legislation also contained a provision designed to discourage “earnings stripping” on the part of U.S. companies, but that had the unintended effect of forcing the U.S. branches of foreign banks to tap U.S. funding markets rather than their home market. These banks have raised several hundred billion dollars over the past few months that previously would have been sourced overseas.
The widening of LOIS appears to be a technical phenomenon, not an indication of growing economic or financial distress.
But, Don’t Ignore Her Entirely
While the cause of LOIS spread widening is not of much concern, we can’t ignore its impact. Other money market rates, such as that on commercial paper, have also climbed, and some debt instruments, including residential adjustable rate mortgages and bank loans to businesses, are pegged to these short-term lending rates. The effect is equivalent to two additional rate hikes by the FOMC. Financial conditions are tightening, slowing growth as they do.
1. Bloomberg, as of 3/28/18.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short-term interest rates around the world.
M2 is a measure of the money supply that includes all elements of M1 as well as “near money.” M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits.
An overnight index swap is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index, such as the overnight federal funds rate, as the underlying rate for its floating leg, while the fixed leg would be set at an assumed rate.
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