Why rising rates in the $US200 trillion inter-bank funding market isn't cause for alarm -- yet

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  • The LIBOR-OIS spread is at its highest level since the 2008 financial crisis.
  • Capital Economics says the rise in bank lending rates is to due technical factors, rather than a fundamental market shift.
  • Despite that, funding costs may climb further as the US Federal Reserve continues to raise interest rates.

The rise in a key inter-bank lending rate has been a talking point in markets over recent weeks, but analysts at Capital Economics (CE) say it’s not yet cause for alarm.

The LIBOR-OIS spread has recently climbed to around 60 basis points — the highest level since the 2008 financial crisis and well above its recent average of around 20 basis points.

However, CE analyst Finn McLaughlin put the move largely down to technical factors, rather than signs of a cracks appearing in the health of the global financial system.

The spread is calculated as the difference between the London Inter-Bank Offer Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate.

The OIS is derived from the benchmark interest rate set by a country’s central bank, whereas LIBOR is the rate at which banks lend to each other on short-term, unsecured terms.

When LIBOR starts to rise, it’s a sign that bank funding costs are increasing. That can be a bad sign, such as in 2008 when bank-funding costs skyrocketed as global liquidity dried up.

So the LIBOR-OIS spread is viewed as a key measure of credit risk in financial markets.

And research from Westpac on Friday cited rising inter-bank lending rates as as one of the main factors contributing to Australian financial stress.

But McLaughlin highlighted three reasons why the recent increase is not a sign of another impending financial crisis.

“First, banks’ share prices have done no worse than the overall market since the start of the year. In contrast, they under-performed dramatically during the financial crisis,” McLaughlin says.

In addition, the credit default swap (CDS) spreads on financial stocks are still low.

A CDS is taken out as a form of insurance on a company’s debt, so the fact spreads are still low suggest there hasn’t been a fundamental reevaluation of risk in the market.

Lastly, the rising LIBOR-OIS spread in this case has been confined largely to funding markets traded in US dollars.

“The LIBOR-OIS spread for other major currencies has remained broadly unchanged, whereas worries about the health of the banking system sparked a widespread shortage of liquidity during the crisis in 2008,” McLaughlin said.

He added that the rise in the LIBOR-OIS spread denominated in US dollars can be attributed to the recent fiscal developments in Washington.

“The initial spike in the LIBOR-OIS spread in early February was largely due to a flurry of Treasury bill issuance following the end of the US government shutdown,” McLaughlin said.

And the fallout from last December’s tax-cut legislation has also had a direct effect on the market.

“The increased incentive for US multinationals to repatriate their offshore holdings — partly held in dollar-denominated bank bonds — may be putting upward pressure on banks’ short-term borrowing costs,” McLaughlin said.

So overall, the fundamentals of the financial system are stronger this time than they were in 2008. But rising LIBOR-OIS spreads will remain a talking point, given the central role the lending rates play in global finance.

McLaughlin cited estimates by the Federal Reserve Bank of New York, which indicate that the sum of financial products derived from the USD-denominated LIBOR-OIS spread amounts to around $US200 trillion.

“As such, the rate’s surge still represents a sizable increase in the borrowing costs faced by many investors and firms. What’s more, we expect these borrowing costs will rise even further as the Fed’s tightening cycle progresses,” McLaughlin said.

Capital Economics expects the US Fed will raise rates by another 125 basis points by the end of 2019 — well in excess of the 32 basis-point rise in the LIBOR-OIS spread since January.

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