Libor-OIS Is Ready to Tighten. Consider It Merely a Reprieve

(Bloomberg) -- The deluge in Treasury-bill supply that helped spur a surge in short-term funding costs is starting to ebb. But banks and other borrowers may only get a brief reprieve from higher U.S. dollar Libor rates.

With the government's April tax deadline set to fill its coffers, Treasury slashed this week's three- and six-month bill auctions by $3 billion each, and the four-week tenor by $10 billion. Those longer maturities are down from record highs. The flood of bill sales, along with Federal Reserve rate hikes, has been driving up rates on commercial paper and pushing the London interbank offered rate higher as well.

The spread on Libor over the overnight indexed swap rate, known as Libor-OIS, has climbed more than 30 basis points since January, to about 59 basis points. The gap may be poised to retreat to 40 to 45 basis points, said Thomas Simons, a money-market economist at Jefferies. But there's a catch: Any pullback is probably going to be shallow because of the expectation that swelling U.S. deficits will still require plenty of bill supply.

Cuts to bill issuance “will have a meaningful impact if you believe supply has been the driving force behind higher Libor and wider OIS spreads,” Simons said. Libor-OIS will still be “relatively wide because bill supply is a persistent issue.”

Treasury is likely to ramp up bill issuance again in coming months, according to Wrightson ICAP economist Lou Crandall.

The outlook for bill supply hinges on the government's “very uncertain budget outlook,” Crandall wrote in a research note Monday.

Assuming an $850 billion deficit for this fiscal year, Treasury could start increasing the one-, three- and six-month bill tenors as soon as May, he wrote. The three- and six-month maturities will probably rise to $54 billion and $48 billion in July, compared with $48 billion and $42 billion this week, he predicted.

To contact the reporter on this story: Alexandra Harris in New York at aharris48@bloomberg.net.

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum, Vivien Lou Chen

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