What Happened to LIBOR-OIS?

One of the stories that have slipped out of the news is OIS-LIBOR spread. The widening of the spread, which is often associated with financial stress, had widened starting late last year. It was near 20 bp last November and proceeded to triple in the following months. The spread peaked a little more than a month ago and has drifted lower to stand near 45 bp now, a two-month low.

The spread between T-bill and Eurodollars is also a measure of perceived risk. When stressed, investors prefer T-bills to Eurodollars. The TED spread widened similarly. It too has fallen back since early April. This lends support to ideas that what happened was a surge in T-bill supply having to do with the US debt ceiling and the Treasury's debt management. The amount of outstanding T-bills fell by around $100 bln since early April.

One of the insights that follow from this is that these spreads may become more volatile. The bill supply may be expected to increase during months when the US runs a budget deficit. During months of anticipated surplus, the Treasury may pay down or reduce its bill issuance.

There may be another force at work: the intended and unintended consequences of the US tax changes. Intracompany loans were one way the companies could shift the tax obligation to a low rate center. The tax reform makes this less advantageous The tax changes had consequences for the branches of foreign businesses who were capitalized by their parent. The tax changes, some analysis suggests, could discourage the stockpiling of cash offshore.

The impact was two-fold. The first we draw comparisons with China's CNY (onshore yuan) and CNH (offshore yuan). US corporates repatriated dollars, bringing them onshore. The LIBOR-OIS and TED spread can be seen as offshore (LIBOR) vs. onshore (T-bills). The second is that it is forcing a change in cash management more broadly.

The cash holdings abroad were often in dollar-denominated instruments, which is why the tax holidays were regularly given to US businesses to accumulate cash offshore often do not appear to have a direct impact on the dollar's exchange rate. Analysis by the Financial Times found that the 30 largest corporate holdings of securities were liquidated by $61 bln or 10% to $524 bln in Q1.

These corporates may have had few securities, but their cash holdings rose. The aggregate growth in cash (and equivalent) holdings rose $34 bln or 17% to $239 bln. Many corporations will use the case for buybacks (shares and/or bonds) and dividends. Businesses also stepped up their capital expenditures in Q1. S&P 500 companies increased their investment in plant, equipment, and other capex by nearly a quarter to $166 bln.

A few corporate strategies sketched by the FT caught our attention. Microsoft reduced its Treasury holdings by 2% and did not seem to alter its dividend and buyback programs. Alphabet reduced the size of its securities portfolio by 1%. Apple reduced its marketable securities holdings by $22 bln or 9%. Its cash holdings rose by $20 bln, but the company approved $100 bln share buyback program and boosted the dividend by 16%. The largest liquidation of corporate securities came from Allergan (78%), Celgene (62%), and Lam Research (58%).

The Federal Reserve itself exerts control over very short-term rates through reverse repo operations, which drain liquidity and protect the floor of the Fed funds range, and interest on reserves, which is paid at the Fed funds ceiling. A simple fact that is under-appreciated is the shift in expectations for Fed policy.

The January 2019 contract may seem to be too distant to be a helpful guide. However, a look at the details reveals a different story. The contract has the second highest open interest of the futures strip (open interest for the July 2018 contract is 306k, and the Jan 2019 open interest is 267k). The January contract also enjoys the highest or among the highest volume. The implied yield stands at 2.305%. It has risen from 1.93% at the end of last year. The 37 bp increase is the market pricing in 1.5 more rate hikes this year.

Conversations with asset managers have shifted. Previously, we had many discussions about the terminal rate for Fed funds. More recently, more interest has focused on the timing of the first cut. There is some thought that by the second half of next year, the fiscal stimulus should have been absorbed and the rate hikes (and oil price increases) could steady the Fed's hand, though that is not in the Fed's forecasts. In addition to oil prices and the yield curve, evidence of late-cycle behavior continues. The 12-month moving average of jobs growth and auto sales peaked (in 2105 and 2016 respectively). Credit card delinquency rates on rising.