Since the turn of the year US dollar borrowing costs have generally risen. In particular the yield curve has become steeper i.e. the difference between short and longer-term rates has increased. 3-month US$ LIBOR has moved from 1.2% to 2.3%, but the "Overnight Indexed Swap" rate - a gauge of the future level of the Federal Reserve's overnight Fed funds rate – has not kept pace: the spread between it and 3-month LIBOR has risen to as high as 0.6%, compared to an average of 0.2% since 2013, with a high/low until recently of 0.4%/0/1%.
The Fed Funds rate is an onshore rate whilst LIBOR is an offshore one. The drivers of change have been the Fed's tightening interest rate policy, increased issuance of Treasury Bills to fund the US deficit, and US corporations moving funds back onshore in response to the Trump administration's corporate tax changes.
This last driver has reduced offshore liquidity – which makes LIBOR increase – whilst increasing it onshore – which moderates rises in onshore benchmarks caused by increased government borrowing.
These developments can challenge a framework of Key Performance Indicators (KPIs) for borrowing.
Firstly, if there is a policy to maintain a War Chest of liquid funds by borrowing them in the 3-6 month tenor and re-depositing them in the overnight-1 month tenor. There will always be a cost associated with borrowing at a benchmark Offer rate plus an interest margin, and re-depositing at a benchmark Bid rate, possibly less a margin as well, even if the maturities are the same on both sides.
The interest margins above and below the benchmarks are transparent and controllable by negotiation. The margin between the benchmark's own Bid and Offer rates is transparent. But the difference between 3-6 month and an overnight-1-month rates is not fixed and is not negotiable by a borrower: it is driven by market conditions – meaning the shape of the yield curve.
The more positive the shape of the yield curve, the more expensive the War Chest policy becomes. The counter-action to this is to reduce the difference in maturities between borrowing and re-deposit, such as spreading borrowings over 2-4 months final maturity instead of all at 6 months and spreading the re-deposits over 2 weeks to 1 month final maturity rather than mainly at overnight and below one week.
Secondly if there is a policy for testing the liquidity of markets to make sure that borrowing lines which exist on paper can be drawn in practice, the normal way of doing this would be to borrow and re-deposit just like the War Chest policy. The cost of testing liquidity thus has similar dynamics to the cost of the War Chest policy, and it increases as the yield curve steepens.
The temptation would be to stop testing liquidity but, in this case, rates have risen precisely because liquidity has reduced, and these are the circumstances that the policy is there to test for. In particular the borrower wants to know that drawings for 3 and 6 months are available in practice, not just drawings in the very short term.
Again, a review of the maturities being dealt could be undertaken, and no doubt borrowers with no such policy or KPI around testing liquidity might be congratulating themselves for saving on its cost. This could prove the be a false economy and the current market conditions are exactly the ones where such a policy and KPIs are beneficial.
Thirdly, if the borrower really needs funds and in US$, this might be the time to go long. The chance of US$ interest rates going back to where they were at the turn of the year must be regarded as less likely than that they will either stabilise near the current level or edge higher still. The treasurer's primary job is to mitigate risk rather than to seek profit, so avoiding increased cost will always be seen as a better tactic than seeking windfall profits.
If the borrower really needs funds but not in US$, it is nevertheless common to draw down US$ and use them as the basis for synthetic borrowings in other currencies, by entering into a swap to exchange US$ for the other currency at spot and re-exchange them forward. A steeper US$ yield curve will alter the forward points, and the KPIs in place around this activity should be reviewed to ensure they do not impose a maximum number of points that conflicts with current market reality.
In addition to this and when the borrower's costs for the base funding in US$ are tied to onshore benchmark interest rates, there could be both a complication and an opportunity.
The complication is that the foreign exchange markets tend to derive their forward points from the offshore interest rates in the two currencies e.g. 3-month EURIBOR vs 3-month US$ LIBOR.
The widening spread between the 3-month US$ LIBOR and the "Overnight Indexed Swap" rate means the rates in onshore and offshore markets are drifting apart: the policies, processes and KPIs around this activity should not assume the base funding cost is linked to LIBOR. They must ensure instead that operations are a perfect "round trip" such that the US$ amount received back at the future date exactly matches the amount required to pay off the US$ borrowing including interest.
If the onshore benchmark has drifted below LIBOR, the all-in cost in the other currency should be attractive relative to a direct borrowing in that other currency and based on its LIBOR, and the exploitation of such opportunities – where they are risk-free – should be factored into the policy and KPIs.
Recent movements in absolute US$ interest rates and in the spreads between onshore/offshore benchmarks call for a review of policies and KPIs, and possibly the installation of new policies and KPIs for the new market situation.
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