(Bloomberg) -- The recent blowout in one of the financial market’s key short-term borrowing indicators may be more a product of technical factors than banking stress, but the negative effects are likely to spread as the gauge deteriorates further, according to Citigroup Inc.
Strategists at the U.S. lender predict that the gap between the London interbank offered rate for dollars and the overnight indexed swap rate will continue to widen, potentially leading to a sharper tightening of financial conditions than central bankers have been anticipating. The differential between three-month rates has already more than doubled since the end of January to 55 basis points, a level unseen since 2009.
The rise “is contributing to a general increase in nervousness around risk assets,” Citigroup strategists Matt King and Steve Kang wrote in a note dated March 18. While technical in nature, the widening nevertheless reflects an increasing scarcity of dollar funding over and above the Fed’s intended tightening, they wrote.
The increase has been fueled in part by the dramatic pickup in Treasury bill issuance that’s taken place since the resolution of U.S. debt ceiling concerns, although Citigroup says this has not been the main driver to date. King and Kang point instead to financing shifts that have taken place in the wake of U.S. tax changes, including a selloff in short-dated dollar credit amid repatriation flows.
Kang wrote in a separate note March 16 that there may be some short-term narrowing of the spread, yet further out Citigroup continues to expect widening pressure.
The spread widened again Tuesday as Libor plowed higher for a 30th straight day. Three-month dollar Libor was at 2.25 percent, its highest level since November 2008, a time when global financial markets were in turmoil.
The widening has so far had little impact on the cross-currency basis, which has traditionally been linked to Libor-OIS, but the Citigroup expect that the pressure will spread there. Though this could be positive for euro-denominated credit, it’s “likely to be more than offset by the global negative,” wrote the strategists, who are bearish on credit markets as a whole.
Libor “is still the reference point for the majority of leveraged loans, interest-rate swaps and some mortgages,” wrote King and Kang.
A rise could also have a less direct impact through wealth effects as “higher money market rates and weakness in risk assets are the two conditions most likely to contribute towards mutual fund outflows,” they wrote. “If those in turn created a further sell-off in markets, the negative impact on the economy through wealth effects could be greater even than the direct effect from interest rates.”
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