Sprott gold report: “QT” or not to “T”? That is the question

Authored by Trey Reik, Senior Portfolio Manager, Sprott Asset Management USA, Inc.

The turbulence which riled U.S. equities in early February spread to short-term credit markets during March. As the S&P 500 Index1 slumped towards ongoing retest of February lows, various measures of dollar funding stress surged to post-crisis highs. Most notably, the Libor-OIS spread exploded to 59 basis points by quarter end, a near six-fold increase from the 9 basis points recorded as recently as mid-November. Just as February equity volatility was dismissed as ill-fated gamma at a handful of short-VIX ETFs, consensus is now writing off the Libor-OIS blowout to temporary market factors including repatriation flows and accelerated Treasury issuance.

Black Swan: the blunt force of the Fed’s monetary brakes

We believe these rationalizations miss a black swan now unfurling in U.S. financial markets: the Fed is on the verge of major policy error by underestimating the blunt force of the monetary brakes it is applying. In this report, we present analysis suggesting the Fed’s dual agenda of rate hikes and QT balance-sheet reduction is already straining global liquidity to the peril of reigning financial asset valuations. In order to arrest deflationary forces, at least in part of their own making, we expect the Fed to scale back telegraphed FOMC policy by yearend.

Fed policy reversal would be the final component of a potent combination of fundamentals which has been developing in gold’s favor during the past several quarters.

Libor-OIS: widest spread on record since GFC

In the interests of clarity, the Libor-OIS spread measures the premium of 3-month Libor (the rate at which 16 “panel” banks offer unsecured U.S. dollar loans to one another) to the fed funds rate (the rate at which banks make collective overnight loans to right-size their respective reserves at the Fed). This spread generally hovers around 10 basis points but can widen when overseas U.S. dollar liquidity is challenged or banks perceive elevated peer-lending risk. As shown in Figure 1, Libor-OIS topped out at 364 basis points during the October 2008 peak of the global financial crisis (GFC). In retrospect, the spread’s initial spike above 50 basis points in August 2007 proved to be a prescient warning for mounting financial stress. For this reason, much attention is being paid to the fact that, outside the GFC, Libor-OIS is now registering its widest spread on record.

Figure 1: Libor-OIS Spread (12/5/01-4/13/18) Source: Bloomberg

As during the summer of 2007, no one knows what the current Libor-OIS surge foretells, but somewhat unsurprisingly, market commentary continues to downplay its significance. Credit analysts cite three general reasons for panel banks to jack-up Libor quotes, with only one of the three signaling definitive financial stress. More benign motivations stem from a general dollar-liquidity shortage or market competition from a dominant lending opportunity, two factors currently at play in global capital markets. Post-tax-bill repatriation appears to be pinching overseas dollar liquidity, and explosive Treasury issuance has been the gorilla on the liquidity dance floor in recent months, siphoning-off available sources of dollar funding.

Fed policy reversal would be the final component of a potent combination of fundamentals which has been developing in gold’s favor during the past several quarters.

A third, more toxic catalyst for widening Libor-OIS spreads can be market concern over the solvency of one or more systemic financial institutions. At least to date, market participants remain confident that bank solvency is not a factor currently in play. Aside from Deutsche Bank’s 32% swoon during February and March, the lack of confirmation from alternate stress barometers – credit default swaps (CDS), cross-currency basis) — supports the view that the Libor-OIS flare-up reflects technical market factors likely to normalize in future months.

Libor matters

Market consensus tends to look over its shoulder in expecting the next financial crisis to resemble prior experience. Along these lines, investors are reassured in 2018 that significant strengthening in bank balance sheets since 2008 renders reoccurrence of anything like the GFC unlikely. We believe dismissing historically wide Libor-OIS spreads under the logic that banks are in relatively good shape amounts to missing the forest for the trees. With $68.6 trillion in U.S. credit market debt towering above GDP of $19.7 trillion, it is rising Libor itself, rather than its indicative spread over fed funds, which should be sounding investor alarms.

Because the world has operated for so long in a zero interest-rate policy (ZIRP) environment, we believe consensus has lost sight of how powerful the Libor mechanism can be in transferring Fed rate hikes through the full continuum of dollar-denominated debts. Current estimates from Gluskin Sheff (3/5/18) and MacroMavens (3/29/18) peg total notional value of Libor contracts at $350 trillion. While the vast majority of these contracts are floating-rate derivatives, JP Morgan estimates in Figure 2, that $7.4 trillion of business and consumer loans float directly with Libor.

Figure 2: Market Size of Libor-Linked Business and Consumer Loans. Source: JP Morgan

We believe the single most important development in financial markets during the past six months has been Libor’s relentless advance. Importantly, the Fed’s 9/20/17 launch of quantitative tightening (QT) distinctly accelerated the slope of Libor’s rise. As shown in Figure 3, none of the four pre-QT rate hikes, nor either post-QT hike (green circles), had much discernible impact on the extended slope of Libor’s advance. The Fed’s QT announcement (red circle), however, separated Libor’s path discernibly from that of fed funds. Since the Fed’s 9/20/17 QT announcement, Libor had increased on 129 of 141 trading days through 4/13/18.

More importantly, while the Fed has hiked rates 25 basis points so far in 2018, Libor has jumped 66 basis points during the same span. Credit analysts can philosophize all they want about whether the current Libor-OIS blowout technically constitutes credit-market stress, but we are pretty sure cranking up the interest rate on $350 trillion of financial obligations at a pace two-and-a-half times the speed of FOMC tightening is the dictionary definition of financial-market stress! We believe Libor’s unruly ascent is an important signal that the Fed’s delicate attempts to vacate the zero bound …read more

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