Ever since the LIBOR–OIS spread shot up from single digit basis points to well over 300 bps during the financial crisis, the gap between the two has been closely watched as a sign of stress in the financial markets. With OIS being almost risk free, the spread is viewed as a measure of short-term liquidity and credit risk.
As the chart below shows, this spread has widened significantly over the past couple of months with a jump of over 11 bps since February 19. The last time the spread hit these levels was in September 2016, however money market reform was, at that time, driving Libor higher and seen as the main driver of the spread.
Once US prime funds stabilized after the rules came into effect in October 2016, the spread slowly returned to its 10-15 bp range. Before that the spread peaked at 50 bps in January 2012 during the Eurozone debt crisis. *Source: Bloomberg, as of Mar. 2, 2018 So what’s driving the spread this time around and are we looking at an early warning sign of another credit crisis?
One of the drivers being touted is the recent tax reform and, specifically, cash repatriation: as US companies repatriate cash (and use it for M&A activity, dividend payments, etc.), the pool of overseas cash declines and banks lose large providers of short term funding. Another possible driver is the record supply of Treasury bonds so far this year while the Fed, formerly a large buyer, is starting to unwind their Treasury purchases made during the QE programs.
Finally, with the probability of a Fed hike on March 21 at 100% and the odds of a hike in June over 80%, another possible driver is the less liquid tenors demanding a premium which should disappear as the rate hikes are realized. We think the recent widening of the spread is a due to a perfect storm of drivers that will dissipate in the coming months. Nevertheless, for floating rate payers impact is clear: the LIBOR portion of their cost of funds has roughly doubled in the space of a year. – See more at: https://jcragroup.com/libor-ois-spread-harbinger-another-credit-crisis/#sthash.JyG001gJ.dpuf