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Funding squeeze

One interesting phenomena in the arcane plumbing of financial markets at the moment is the sharp increase in short term funding costs.

The chart below shows the spread between the yield on bank bills (that is, the interest rates paid by banks to borrow in the interbank funding market) compared to the interest on overnight indexed swaps (OIS rates). Overnight indexed swaps are a financial instrument linked to the official overnight cash rate. Effectively OIS are truly risk free, while the bank bill rate (BBSW) contains a credit/liquidity spread for the credit risk of the interbank market.

Usually this spread is very low – typically around 20 basis points. However, it does shoot up in times of financial crisis. For example, on a month‑end basis the BBSW-OIS spread hit 0.76% during the GFC (it actually hit a peak of around 100bp during the absolute peak of the crisis).

The BBSW-OIS spread is a similar concept to the TED spread, which is a measure of financial system stress in the US.

Interestingly, Australian funding markets have seen a surge in BBSW-OIS spreads with current spreads around 60 basis points (that is three times normal). Hardly an outcome you would associate with the recent 10 year high in equity markets!

Why is this the case? The simple answer is we don’t fully know.

Tax reforms in the US have significantly impacted global debt funding markets. The changes in US tax law mean that it now makes sense for large US corporates to repatriate profits that were previously held offshore (and available for short term funding in global debt markets). This has resulted in a funding squeeze – and it is worth noting that the equivalent spreads in offshore markets have also increased (but not by quite the same amount as in Australia). Australia is potentially more affected than other markets due to our banking systems reliance on offshore wholesale funding, and because, somewhat unusually, Australian short and long-term rates are falling below those in the US. Part of Australia’s usual appeal to offshore investors is our higher interest rates.

Under this benign interpretation you would expect this spread differential to moderate as global funding markets digest the implications of different cash management practices of US corporates.

However, it is worth watching this space closely, if these elevated spreads are maintained, or increase, this is defacto to almost two rate rises (given BBSW underpins the vast majority of floating rate borrowing in Australia). Not necessarily what the RBA might have had in mind in an environment of softening house prices.

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