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Crisis-Era Risk Gauge Flares Up as Trump's Budget Deficit Swells

Bradley Keoun

President Donald Trump's budget deficits are starting to wreak havoc on U.S. money markets.

A key gauge of risk in money markets has surged to levels not seen since investor fears swelled in 2011 and 2012 over the deteriorating finances of Portugal, Italy, Greece and Spain, Bank of America Corp. analysts wrote Tuesday in a report.

And the trend is set to worsen, raising borrowing costs for banks and other corporations that borrow cash to meet short-term ends, according to the analysts.

The risk gauge, which also flared up during the financial crisis of 2008, has historically been viewed as an indicator of deteriorating creditworthiness among banks. Usually, the measure rises when banks get nervous about lending to each other.

Amid the fears of insolvency among the European countries earlier this decade, the spread shot up to about 0.5 percentage point. During the 2008 crisis, it surged to a staggering 3.5 percentage points.

But now, according to Bank of America, the risk gauge is rising partly due to the flood of new U.S. Treasury bills being issued by the government to fund Trump's tax cuts and spending plans. The Treasury Department has issued more than twice as many bills in the past five weeks as in all of 2017, the bank's analysts noted.

The surging Treasury-bill issuance is soaking up cash from investors, forcing borrowers who need short-term loans to pay up to attract needed funds. At the same time, the Federal Reserve is reducing its vast holdings of Treasury bonds and mortgage-backed securities, creating an additional source of demand for investors' cash.

The Bank of America analysts, led by Mark Cabana, predict that the three-month London Interbank Offered Rate, or Libor, which is the interest rate that banks pay for loans, will rise to 2.16% by the end of the month, up from about 2.11% currently. That increase has broad implications for corporate borrowers, since trillions of dollars of corporate loans and derivatives are linked to the rate.

But the main risk gauge causing fresh anxiety now is the difference, or spread, between Libor and the Overnight Indexed Swap, or OIS, which represents traders' expectations for the Federal Reserve's benchmark interest rate over the coming months.

Traders analyze the Libor-OIS spread because the Libor rate theoretically incorporates the risk that lenders might not get their money back, while OIS reflects almost no credit risk. So a widening spread between Libor and OIS, all things being equal, usually signals deterioration in perceptions of banks' creditworthiness.

Now, as investors anticipate Trump's $1.5 trillion of tax cuts over the next decade, in addition to some $300 billion of additional spending approved in February, the rapidly increasing supply of new Treasury bills is overwhelming markets. The Treasury issued some $283 billion in bills last week, characterized as a "whopping" amount by the Bank of America analysts.

And the pressure has caused the Libor-OIS spread to more than quadruple since late 2017, to almost 0.45 percentage point recently, according to the bank's report.

"This widening is not reflective of heightened bank credit concerns, but rather due to a number of factors that have worsened the supply-demand backdrop and impacted the price of funding," the analysts wrote.

The spread could approach 0.5 percentage point before easing in April as the supply of new Treasury bills is cut due to incoming tax receipts, according to the report.

But the gauge could narrow "only marginally" before starting to widen again, the analysts wrote, since Treasury-bill supply is expected to pick up later in the year. The measure could end the year at a still-elevated 0.4 percentage point, they predict.

The Federal Reserve, which has been raising interest rates as the economy accelerates, is concerned enough about the trend that it asked Wall Street dealers specifically about the Libor-OIS spread in a recent survey, the analysts noted. Since the Libor rate is so widely used to set rates on loans and financial contracts, any increase could act to slow economic activity, similar to the impact of the Fed's own rate hikes.

"We do not think the rise in Libor is yet sufficient to derail the Fed from their gradual tightening cycle, but they will likely be more attuned to financial conditions given the recent rise," according to the bank.

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