Angst Over Year-End Funding Pinch Fuels Options: Liquidity Watch

(Bloomberg) — Trepidation about a year-end U.S. funding squeeze is emerging in eurodollar markets.

Positions to hedge against a higher rate for three-month dollar Libor, the benchmark U.S. bank lending rate, have been building for the past three sessions. The bets are reflected in rising activity in December 2020 Eurodollar puts, pushing daily trading volumes almost 30% above the 20-day average, according to open interest data from the CME Group.

Notably, the strike targeting the benchmark to rise to 0.375% has been particularly active. It was fixed at 0.25% on Tuesday, with futures markets pricing a year-end rate of 0.295%.

Those concerns haven’t yet surfaced in other corners of U.S. funding market, as the Federal Reserve’s massive liquidity injections since the March upheaval have given traders comfort. But JPMorgan Chase & Co. warned recently about the risks of a squeeze, specifically in the currency swaps market, as they may be more at risk of balance-sheet reductions.

FX Markets Are Too Calm About Year-End Stress: Liquidity Watch

The recovery in funding markets is also reflected in the gap between expected Libor rates and the overnight index swap — a key gauge of banking sector risk. This spread, known as FRA-OIS, is seen widening six basis points from current levels, to 24 basis points by year-end. That’s still well below peaks in excess of 100 basis points at the height of the market turmoil.

This Fed backstop has some market watchers even more sanguine about funding conditions around the turn of this year. BMO Capital Markets rates strategist Jon Hill reckons the risk priced into FRAs based on Libor is excessive, as “we’re in a much different world today” relative to years gone by.

“If anything, I think the risk premium is a bit overstated,” he said.

(Adds strike level in third paragraph)

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