Historically, blowing out short-term funding rates, whether measured by the TED Spread (the difference between LIBOR and 3 month TSYs), or the 3 month FRA-OIS spread, have been an indicator of funding stress and heightened systemic risk. This had been the case as long as 2010, around the time of the first Greek bailout, when rapid moves in such spreads suggested that the ECB was losing the war (it was, until Draghi’s infamous “Whatever it takes” speech), and as recently as last December, when as a result of the tumultuous moves in China, the TED Spread blew out to multi-year wides.
The reason this is once again topical is because as the chart below shows, the TED-spread, which barely moved in the aftermath of Brexit, has moved sharply wider over recent days, prompting some to ask if despite record highs in the S&P500, there isn’t yet another unnoticed troubling liquidity or funding situation developing behind the scenes.
However, as we discussed previously when we observed the sharp move in swap spreads, this may be the one time when the move wider in funding indicators happens to be perfectly inocuous and has to do with a change in the regulatory encironment instead of indicating some unseen liquidity threat.
As Goldman’s Elad Pashtan writes, in the aftermath of the United Kingdom’s vote to leave the European Union, investors and policymakers have kept a close watch on funding markets for any signs of financial stress. These fears did not materialize – courtesy of the rapid promises by central banks to intervene and propr up asset prices – and most global equity markets, including those in the US, have since more than recovered their post-Brexit losses. However, Goldman cautions, in recent days indicators of financial stress have perked up notably. For example, the 3-month FRA/OIS spread—a gauge measuring the difference between forward 3-month Libor and OIS rates—rose sharply, reaching its highest levels since the depths of the European sovereign debt crisis (Exhibit 1, left scale). Other measures of dollar funding costs, including commercial paper rates and cross-currency basis swap spreads, have also turned higher (Exhibit 1, right scale).
And while unexpected increases in banks’ dollar funding costs can be a sign of financial market stress, other market indicators paint a more sanguine picture. For example, credit default swap rates for the Libor panel banks have actually edged down in recent days, and remain well below levels that prevailed during the European sovereign debt crisis (Exhibit 2).
As noted earlier in the day, rather than signaling dollar funding stress, the recent increases in money market rates likely relate to soon-to-be enacted money market regulation.
On October 14, 2a-7 money fund reforms will require some prime money market mutual funds (those that invest in non-government issued assets) to float their net asset value (NAV) or, under certain circumstances, to impose redemption gates and liquidity fees on redemptions. Rather than face these regulatory constraints, many investors have started pulling assets from prime funds, and a number of prime funds have converted to government-only funds (which are exempt from these regulations). Since late-2015 alone, prime fund assets have declined by nearly $450 billion, reducing the supply of dollars that funded private sector short-term liabilities (Exhibit 3).
Adding to the impact of the decline in prime fund assets, the behavior of the remaining prime funds has also pressured shorter-tenor funding rates. As part of the 2a-7 reforms, prime funds are required to hold at least 30% of their assets in securities that are convertible to cash within 5 business days, or otherwise face either liquidity fees and/or redemption gates. In anticipation of these changes, many prime funds have lowered the weighted average maturities (WAM) of their assets in recent months, reducing the supply of dollars available at longer tenors (Exhibit 4).
Goldman’s conclusion:
We do not think recent money market volatility will worry policymakers at this stage. However, Fed officials are likely to keep close tabs on how the 2a-7 reforms impact the usage of the RRP facility. As money market assets continue to shift into government-only mutual funds—many of which have access to RRP—it is likely that facility usage will rise. Indeed, we think that these money fund reforms are a key reason why Fed officials have yet to cap the RRP facility, despite previous communications suggesting discomfort with currently uncapped levels. Accordingly, we do not expect the Fed to announce a cap to the RRP facility until after the October 14 2a-7 compliance deadline, at the earliest.
In this specific case, we agree with Goldman, however the implication is somewhat disturbing. Now the regulatory intervention is set to pressure what have traditionally been reliable metrics indicative of funding stress and systemic risk, among them swap spreads, the TED-Spread and the FRA-OIS spread, the market is about to lose perhaps the last metric indicative of underlying tensions. After all, with central bank intervention having broken all conventional signalling pathways (recall that as of this moment global is QE Running At Record $180 Billion Per Month and Rising), including equities, corporate bonds and Treasuries, there will no longer be any reliable sources hinting at fundamental risk in the market, certainly for the short-term and perhaps over an indefinite amount of time.
We can only hope that central banks don’t make a mess of things in the near future, as differentiating between the signal of real market stress and the noise resulting from the shift due to 2a-7 reform, will now be impossible, and thus it will also be impossible to gauge if there is something truly broken with the market, at least until such a “breakage” becomes all too apparent for everyone to see.
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