Views From the Floor

In this week’s issue, we take a deeper look at the spike in the 3-month FRA-OIS spread and repo rates.

Things that Go Bump Overnight

Three big 1-day moves have occurred in the past few days: the surge in crude oil after the attack on a Saudi refinery, the drop in momentum and the spike in the FRA-OIS spread. Respectively, these represented moves of six, five and eight standard deviations; for context, on a normal distribution, a seven standard- deviation move occurs once every 3 billion years.1

In our view, there is no immediate consequence to having high volatility in three uncorrelated markets simultaneously. Big moves are not unprecedented, nor do they mean that portfolio managers should duck and cover. Still, the last time similar volatility spikes occurred in all three markets was during the Global Financial Crisis.

Funding Markets: What Is Causing the Spike in the 3-Month FRA-OIS Spread and Repo Rates?

Of the three big moves in Figure 1, the 3-month FRA- OIS spread stands out as potentially concerning, in our view. The FRA-OIS spread is the difference between 3- month Libor (the inter-bank lending rate) and the overnight index rate (the risk-free rate set by central banks). In the case of the US dollar, this would be 3- month Libor less the Federal Funds rate. The spread is seen as a measure of funding stress or tightness: a spike indicates an increase in the short-term cost of funding for the banking sector (Figure 1).

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As of 20 September 2019.

The recent increase in the spread has been driven, we believe, by an increase in US T-bill issuance, which has taken liquidity from the bank-dealer community at the same time as corporate tax payments have seen money market fund outflows. Crucially, this is happening at a time when the Federal Reserve’s balance sheet contraction has reduced the level of excess reserves in the system. As such, bank balance sheets have become stretched, and there is less short-term capital available to keep funding markets liquid, and funding costs down.

In response, the Fed conducted an overnight repo operation, using open-market purchasing to try and move the effective Fed Funds rate back into its target range of 2%-2.25%, the first time this has occurred since 2009. At this week’s Federal Open Market Committee, the interest rate on excess reserves (‘IOER’) was also cut; this was to incentivise banks to park any excess liquidity in short-term funding markets rather than on the Fed’s balance sheet.

In our view, the Fed is being forced to grapple with the effects of having normal(ish) monetary policy for the first time in a decade. Its previous policy of quantitative easing had been a bulwark against this kind of squeeze: by holding large stock of Treasuries on its balance sheet, which could then be loaned out, the Fed had acted as a safeguard against liquidity shortages. We would point out that before 2008 and the advent of QE, the Fed was a fairly frequent actor in the overnight repo market. It should be stressed that the process of discovering where the floor on excess reserves was always going to be imprecise.

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As of 19 September 2019.

The low interest-rate era since 2008 has been taking on some increasingly odd characteristics; one of them being that Switzerland’s entire government bond market now trades with negative yields (Figure 1). Switzerland is following in Denmark’s footsteps, which earlier in July, became the first country to see its entire yield curve turn negative.

With contribution from: Ed Cole (Man GLG, Managing Director) and Andrew Freestone (Man GLG, Portfolio Manager).

1. https://www.nottingham.ac.uk/business/businesscentres/gcbfi/documents/cris-reports/cris-paper-2008-3.pdf