One Market Gauge Is Signaling Fed Should Continue to Tighten Policy

A key measure that tracks stress in U.S. money markets tumbled to near its lowest level in seven years -- a sign of loose financial conditions that could prompt the Federal Reserve to maintain its pace of tightening monetary policy.

The three-month dollar Libor-OIS spread -- the difference between the rate at which banks lend to each other and the market's expectations of central bank rates -- fell below 0.1 percentage point on Monday. It was 0.0998 percentage point, the lowest since August 2015, according to Steven Zeng, interest rate strategist at Deutsche Bank. The spread's lowest level in recent years was in March 2010, when it hit 0.06 percentage point.

As markets fret over whether the Fed will raise short-term borrowing rates too quickly, potentially constraining growth in the economy, the narrowing Libor-OIS spread is one indication that the U.S. central bank has the latitude to stay on its course of raising interest rates. The Fed lifted rates in December and March and is expected to act again at its June 13-14 meeting.

Tracking the spread helps investors and policy makers monitor the health of money markets. A higher reading signals growing stress, while a lower one indicates easy funding conditions. The gauge soared to a record in October 2008 as banks lost trust in each other and money markets seized up.

To some analysts, the narrowing spread reflects the easy monetary policies that still dominate financial markets and could breed complacency in investors. The Fed has only been raising rates gradually and the European Central Bank and the Bank of Japan have continued bond-buying stimulus programs. Prices of assets from stocks, leveraged loans, bitcoin to gold have gone up in the meantime.

"The problem for the Fed is that despite its rate increases, market signals remain unresponsive, potentially generating financial asset bubbles," said Mark Cabana, head of U.S. short-rates strategy at Bank of America Merrill Lynch and a former trader and analyst at Federal Reserve Bank of New York.

Ample liquidity also offers an explanation why U.S. Treasurys have strengthened this year alongside a roaring stock market, a shift from late last year when bonds sold off as equities rallied. The yield on the 10-year Treasury note closed at 2.182% Monday, down from 2.446% at the end of 2016.

But to many others, the narrowing Libor-OIS difference is more a byproduct of postcrisis banking regulations and the money-market reform that kicked in during October. Continued thirst among investors for income in a low-yield world has also contributed to the spread's narrowing.

The banking system is more resilient because of the regulations since 2008, as firms shifted away from short-term borrowings without collateral, which have interest rates tied to Libor. Instead, banks are issuing longer-term debt in the low-yield environment as a way to reduce rollover risk, the risk from having to replace maturing debt.

"The risk is that funding would run away for the banks in time of market stress," said Steve Kang, interest rate strategist at Citigroup who specializes in money markets. "Less reliance on short-term funding means more stable funding for banks and there is still lots of liquidity in the system."

A key form of short-term corporate debt has fallen to roughly half of where it was 10 years ago. U.S. commercial papers outstanding stood at $987 billion as of May 24, data from the Federal Reserve Bank of St. Louis show. The amount topped $2 trillion in 2007.

The Libor-OIS compression has also been driven by the return of stability in U.S. money-market funds that focus on riskier instruments, which are called prime money-market funds. New money-market fund regulation that became effective in October caused investors to move money into safer funds -- spurring large outflows from prime money-market funds.

But in the past few months, prime money-market funds have attracted money again, highlighting a global demand for yield. Investors get higher yields on commercial papers, a popular form of short-term corporate debt, relative to Treasury bills, or government debt maturing in a year or less.

"Everyone is starving for yields, chasing different assets," said Jim Madison, money-market trader at Manulife Asset Management.

Prime funds' total assets stood at $609 billion at the end of April, according to data from the U.S. Securities and Exchange Commission. It is still down from $1.7 trillion a year earlier, but the number was the highest since September.

The Treasury's large paydown of T-bills earlier this year linked to the looming debt ceiling was also equivalent to cash injections into global markets. Investors who received the cash needed a new home to invest, adding to the scramble for yields and compressing the Libor-OIS spread further, say some analysts.

Still, investors should expect the Libor-OIS spread to widen from the current extreme levels if the Fed continues to tighten policy, according to Jerome Schneider, head of the short-term and funding desk at Pacific Investment Management Co.

"Investors should be preparing to embrace for higher benchmark rates in the coming months and find ways to be defensive of interest-rate risk while earning income," he said.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

June 06, 2017 07:44 ET (11:44 GMT)