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Money markets wary, not yet flashing red as Fed offers tonic

4 Mins read

(C) Reuters. FILE PHOTO: Federal Reserve Board building on Constitution Avenue is pictured in Washington

By Tommy Wilkes, Saikat Chatterjee and Gertrude Chavez-Dreyfuss

LONDON/NEW YORK (Reuters) – A precipitous drop in global equity markets has seeped into higher demand for dollar funding, putting investors on guard for the kinds of money market stresses that tend to exacerbate cross-border financial crises.

While there are some signs of investors hoarding funds to shield against further turmoil, markets have not yet reached the point where borrowers are scrambling to secure short-dated funding, according to analysts such as Marija Veitmane, senior strategist at State Street (NYSE:STT) Global Markets.

Memories still linger of the sort of money market seize-ups that triggered the 2008 global crash or those seen during the 2011 euro zone crisis that effectively shut European banks out of interbank lending.

So, investors are keeping a close eye on the following barometers of market stress:

FX SWAPS

Non-U.S. banks tap into liquidity pools in foreign exchange swap markets to secure their dollar funding needs.

These instruments shot into the limelight during the financial crisis and the euro zone debt crisis when global regulators poured in billions of dollars to unfreeze the market.

Three-month euro/dollar basis swaps , which measure demand for dollars from European borrowers, rose sharply to minus 31 basis points on Monday, double late February levels – signaling a willingness to pay more to get hold of dollars.

But the levels are far from the highs seen last year or during the euro zone debt and financial crises.

Dollar/yen basis swaps have moved more aggressively, but historically that level has been much higher too.

The dollar usually gains during times of market stress as a worsening funding situation triggers a stampede into the world’s most liquid currency, but the greenback has actually weakened in recent days thanks to plunging U.S. Treasury yields.

(GRAPHIC: FX basis swaps – https://fingfx.thomsonreuters.com/gfx/mkt/13/3083/3048/FX%20basis%20swaps.png)

U.S. BANK STRESS

Another widely watched indicator is the U.S. LIBOR-OIS spread, which measures the difference between secured and unsecured lending in the United States and seen as one gauge of money market stress.

A higher spread suggests banks are becoming more nervous about lending to each other.

The U.S. Federal Reserve on Monday stepped up its repo operations by increasing the size of its fund injections to head off any further signs of stress.

The one-month spread had earlier on Monday rocketed to 42.78 bps , up from as low as minus 5.85 bps at the start of March.

Still, that is only the highest level since late 2018.

Analysts at Barclays (LON:BARC) said they believed the Fed’s decision to raise repo operations was “driven more by deteriorating market sentiment about credit and recession risks than a genuine pullback in unsecured funding markets”.

(GRAPHIC: U.S. bank stress gauge – https://fingfx.thomsonreuters.com/gfx/mkt/13/3067/3032/US%20bank%20stress%20gauge.png)

Vitor Constancio, ex-European Central Bank vice president, said on Twitter that this was “not like 2008 because it’s an economic shock that didn’t start in the financial sector. Money markets not frozen, no concerns with banks’ solvency”.

But he warned that the more elevated spread did indicate some “mistrust within the financial system”.

U.S. FORWARD RATE AGREEMENT AND OVERNIGHT INDEX SWAP MARKET

The spread between the three-month forward rate agreement and the three-month overnight index swap rate reflects rising interbank lending risk or dollar hoarding, analysts said.

The FRA-OIS spread measures the difference between the three-month Libor or the inter-bank lending rate and the overnight index rate, which is the risk-free rate set by central banks.

In the case of the U.S. dollar, this would be the three-month Libor less the Federal Funds rate. The spread is a gauge of funding stress or tightness, with higher spreads indicating a rise in the short-term funding costs for the banking sector.

The spread on Monday was 48 basis points, said Gennadiy Goldberg, senior rates strategist at TD Securities in New York, the widest gap since early 2018 when the market experienced some volatility and funding questions.

Before that, the spread had expanded to 58 basis points at the height of the European sovereign debt crisis in 2011.

SYSTEMIC RISK INDEX

Another measure shows a steep rise in systemic risk, although it is the size of the move rather than the absolute level that is concerning.

State Street Global Markets’ Systemic Risk Index has jumped from less than the 10th percentile to nearly the 100th, but that only brings it to levels last seen in October.

It underlines just how subdued markets had been in the run-up to the coronavirus-induced sell-off.

(GRAPHIC: SSGM – https://fingfx.thomsonreuters.com/gfx/mkt/13/3084/3049/SSGM.png)

VOLATILITY SURGE

Volatility across asset classes is surging.

That illustrates how investment strategies centered on borrowing in low-yielding assets to buy relatively higher-yielding markets are being rapidly unwound.

The equity VIX index (VIX), which measures implied volatility in the S&P 500 and is known as the “fear index”, hit 62 on Monday, its highest since the 2008-2009 financial crisis.

That is a jump of 300% in less than three weeks.

Broader currency market volatility, as measured by Deutsche Bank (DE:DBKGn) <.dbcvix>, has shot up to its highest since 2017. In specific currency pairs, such as dollar/yen, the surge is even more notable – hitting levels last seen in 2009.</.dbcvix>

But the volatility jump must be seen in the context of a market unusually calm – and complacent – before panic selling started.

(GRAPHIC: Market volatility soars – https://fingfx.thomsonreuters.com/gfx/mkt/13/3081/3046/market%20vol.png)

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