Mwahaha! Bank funding costs begin to stress

Westpac has the note:

Fears around funding have started to impact rate sets pushing BBSW higher despite little reason for a sustained AUD funding squeeze. BBSW rate sets have been rising fast 3m BBSW vs 3m US CP Swapped into AUDBBSW rate sets and BBSW-OIS spreads (left chart) have been widening rapidly, with 3m BBSW higher by 5.5bps and 6m BBSW up by 15bps over the past week and the 3m-6mBBSW spread is as wide as it has been since 2017. So what does this mean? Given the amount of liquidity in the system as a result of TFF and QE policies, we do not see this as an AUD funding squeeze. There is plenty of short term cash in the system and banks do not need to significantly increase their short paper issuance in AUD. Indeed, some of last week’s rate sets were made on very little or even no volume. Rather this reflects the global situation and fears and volatility that arise from the geo-political crisis. During these episodes there is a natural demand for USDs as market participants try to protect their near term funding needs. Indeed, while US CP spreads have been rising prior to the war beginning, ahead of the Fed’s hike cycle, there is now a sense that some European companies are scrambling for USDs. The chart at right indicates the relationship between these CP yields and BBSW. There might be some element of “bring forward” of expected BBSW-OIS which has been on the radar given that the RBA has stopped growing its balance sheet, however it seems too early for that to be a major factor. So we believe that the recent moves will eventually settle lower, albeit given that whether or not BBSWrises or falls medium term is a one-way bet, perhaps the average BBSW rates ets over the next few weeks will remain higher than those that we have seen in recent months.

Longer duration wholesale funding spreads are widening fast as well though at 40bps they are still relatively narrow:

There may be no obvious local reason for this. But there are plenty of global reasons for it. As noted yesterday, global banking spreads are widening at the source:

US Funding Stress: Ripples in the Water

•Bank unsecured funding levels have risen amid the financial reverberations of the Ukraine invasion. CP-OIS, Libor-OIS, and cross-currency basis have all widened. However, we argue that this is more a function of markets pricing in the potential of significant credit losses in the banking system. Higher credit risk premiums should also widen CP-OIS.

•We don’t see signs of dealer balance sheet constraints, which may be symptomatic of lower leverage in the system. Repo rates are well-behaved and dealer inventories are not high. This could change if credit continues to deteriorate, but for now, this channel of funding stress is not significant.

•There is a strong correlation between CP and Libor but the recent widening in Libor-OIS has not fully caught up with the move in CP-OIS. This suggests that even if CP spreads stabilize at current levels, Libor settings should continue to move higher. Note that FRA-OIS averaged around 25bp between 2015 and2018 when the Fed was hiking rates. Current levels have now jumped above these more “normal levels” and the pace of the increase is certainly concerning.

•Supply-demand trends in the CP market will be important to track going forward. Foreign CP issuance increased sharply over the past year. Note that prime money fund assets have declined since COVID, so the demand for CP likely came from other sources of short duration cash. CP spreads could be pressured higher if foreign banks continue to rely on CP for funding.

•The widening in CP-OIS spreads hints at USD funding stress amid high uncertainty, but it seems to be more about the cost of funding rather than the availability of funding. In addition, if USD funding pressures continue to increase, there are various central bank backstop facilities available. So far these facilities have not been accessed, but we will continue to monitor their usage. From an economic standpoint, it is cheaper to access the swap line than the private market (using CP or cross currency basis).

And there may, in particular, be a commodities linkage as Russian assets turn toxic. Credit Suisse:

Yes, we got central banks’ need to step in to calm funding market pressures this week wrong (still no need yet), but we got the direction of spreads right – on February 24thwewarned about an imminent sentiment shift in funding markets. There was no premium last week but there is some funding premium now, and it feels that things can get worse still. So net-net, our call was absolutely right.

Our point with the Lehman analogy last Sunday was to underscore the point that just as the market didn’t realize the complexity and interconnectedness of the financial system then, it may not realize the same today. Again, we are not saying that we are about to have another Lehman moment, only that things can get much worse than you realize. When you rip $500 billion of FX reserves from the system, sanction and de SWIFT banks (which goes live March 12th), and force Western banks and commodity traders to self-police and not trade commodities from the single-largest commodity producer of the world (Russia), unforeseen things can happen and do happen. If you believe that the West can craft sanctions that maximize pain for Russia, while minimizing financial stability risks in the West, you could also believe in unicorns. Yes we were also wrong on Sunday about the trigger of funding pressures – it’s not the Bank of Russia’s inability to roll FX swaps or de-SWIFTing that caused funding pressures to date, but rather the market’s self-imposed unwillingness to buy, move, or finance Russian commodities that’s driving the current massive bid for cash. Bloomberg called the commodities rally “historic,” and so the margin calls must be historic too.

Who is getting the margin calls? Market participants that are long commodities either in the ground or in transit and want to lock in a price by shorting futures. These include every commodity producer in the world including Russia, and every major commodity trading house, respectively. Again, we do not know if this is the case, but it’s reasonable to wonder if Russian commodity producers are experiencing margin calls now, and if they have the resources to pay – could they choose not to pay because their sovereign’s FX reserves were seized? We are not saying they will, but this is a risk one needs to consider. As for the commodity traders, which are suffering a correlated surge in commodity prices (Russia and Ukraine export pretty much everything imaginable), margin calls can be funded by drawing on credit lines from banks, issuing CP, or swapping FX.

One lesson from the March 2020 liquidity crisis was that corporate credit lines (which have a low drawdown assumption according to Basel III) can be drawn across all industries and across all geographies at the same time in a pandemic, and the lesson about the present crisis is that you can have a rally in all sorts of commodities from oil to gas, fertilizers, wheat, palladium, and neon during war, especially if the G7 force the world to self-police and boycott Russian stuff.

Commodities are collateral…

…and every crisis occurs at the intersection of funding and collateral markets. Urals spot trading at a discount to WTI is like subprime CDOs going from AAA to junk. Will all commodities sourced from Russia trade at a significant discount?

Is it possible that the Western boycott of Russian commodities is turning AAA commodities to junk? Does going from AAA to junk trigger margin calls? You bet!

Leverage and liquidity are also important.

In 1998, we had Russian bonds and a leveraged LTCM. In 2008, we had mortgages and leveraged banks and shadow banks. In March 2020, we had leveraged bond basis trades. You see the pattern? Collateral, leverage, funding.

In 1998 and 2008, collateral went bad and a funding crisis hit as a consequence.

In 2020, corporations drew on credit lines, which sucked funding away from leveraged bond RV trades, which then triggered a forced sale of good collateral.

Crises happen either because collateral goes bad or funding is pulled away– that’s been the central lesson in every crisis since 1998. Now on to today…Marc Rich’s legacy in the annals of global finance was to introduce the concept of leverage and borrowed money into commodity trading. It’s simple: a bank lends you the money to lease ships and buy commodities to deliver them sometime and someplace in the future at a locked-in price (via short futures).

Does that ring a bell?

A bond RV fund is long the bond, short the future, and funds the package in the repo market. That’s the same as a commodity trader moving stuff around.

But if collateral spoils, funding is impossible to come by and spot price spikes are triggering margin calls. March 2020 all over again? Probably not the same size, but please be mindful of the parallels and the funding and collateral linkages…

We could be looking at the early stages of a classic liquidity crisis that has elements of both collateral and liquidity problems (1998 and 2008), where some players – commodity traders – are not regulated and have no HQLA, and some players – state-linked commodity producers – are not liquid enough because their backstop – the Bank of Russia’s FX reserves – ha s been seized. I don’t know, but neither do you and that’s worth some funding or risk premium.

Especially in Australia. It’s early days but moving fast and the RBA had better be on alert to restart its TFF!

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