The surprise outcome of last Thursday’s Brexit vote caught many investors flat-footed. Global central bankers and others charged with liquidity management, however, have merely lifted an eyebrow.
In part, this is because short-term funding market conditions prior to the vote were decidedly different than before previous events that prompted funding contagion. Central bankers had been advertising a crisis-level prophylactic toolkit, including excess funding mechanisms, quantitative easing (QE) programs and legacy swap lines for foreign exchange. So far, these efforts appear to have confined market concerns to pricing volatility – averting deterioration in funding conditions for institutions that could serve as a prelude to a systemic liquidity event.
More telling has been the relevance of “traditional” indicators of funding stress. Thus far we have seen little evidence of stress in indicators such as Libor, Libor/OIS (Overnight Indexed Swap) rate spreads, or rates on commercial paper (as occurred during the financial crisis of 2008 and the European banking crisis of 2011). In fact, many of these indicators have tightened over the past few trading sessions, suggestive of more normal conditions.
Although front-end funding spreads have widened marginally for a handful of UK-domiciled financial institutions, this should come as no surprise given the structural changes they will encounter over the secular horizon. Even traditional collateralized funding markets like repos have behaved in a predictable pattern, pricing in rate premiums as we approach the June quarter-end reporting period, a trend that began even before the Brexit results had been announced. Granted, there have been periods of intra-day funding needs that buoyed overnight repo levels for Treasuries to 1% and beyond, but these appear to be discrete episodes.
Still, we are watching keenly for evidence of change. Here are some of the new and refined indicators of market liquidity and stress we have been monitoring for real-time or lagged changes:
- Use of global central bank (and Federal Reserve) foreign exchange (FX) swap lines – specifically, swap/basis markets for indications of market
levels approaching the threshold of swap line usage (https://www.federalreserve.gov/releases/h41/)
- Daily use of the Federal Reserve Reverse Repo Facility
- Changes in interdealer general collateral financing (GCF) repo rates
- Movements in the Overnight Bank Funding Rate (OBFR) Index, which details fed funds and eurodollar transaction costs
- Changes on dealers’ haircuts (overcollateralization) on collateral for repurchase agreements
- Moves in short-term unsecured financing costs (commercial paper), specifically for Yankee Banks.
While central banks are more prepared to stem volatility in funding markets than in 2008, prime money market funds are starting with much shorter exposures than in 2008 and 2011. Thus, it will be important to watch weekly changes in exposures to UK and European Union financial institutions for any swift reduction in availability of wholesale funding. However, any reduction in exposures is likely to be via maturities in commercial paper exposures, and not via repo markets, given the shortage in safe assets for government money funds.
Finally, it is worth mentioning that normal seasonal pressures arising from quarter-end reporting this June will continue to influence many markets and blur some of these indicators. However, while short-term market moves so far suggest that the fallout from the Brexit vote has been largely contained, considerable uncertainty remains.