U.S. banking stress indicator could worsen after Fed hike

By Mehnaz Yasmin

(Reuters) -An indicator of credit risk in the U.S. banking system may be showing signs of stress, as the Federal Reserve's aggressive rate hike path ratchets up expectations of economic pain.

The so-called FRA-OIS spread, which measures the gap between the U.S. three-month forward rate agreement and the overnight index swap rate, increased to 29.55 basis points on Thursday, its widest since May 23, according to data from Refinitiv. The measure was at -11.66 bps earlier in the week.

Widely viewed as a proxy for banking sector risk, a higher spread reflects rising interbank lending risk.

"The recent spike in the spread between forward rate agreement and overnight index swap rate is concerning," said Jordan Jackson, a global market strategist at J.P. Morgan Asset Management. "As the Fed turns more hawkish, there is a rise in recession concerns and that is increasing the underlying credit risk."

The central bank this month also began allowing bonds to mature off its more than $8 trillion balance sheet without replacing them, a process called quantitative tightening that can potentially sap liquidity in the financial system.

"Now that quantitative tightening has officially started, we have seen reserve drainage pretty persistent over the last several months," Jackson said, adding that he expects the FRA-OIS spread to widen even further.

The Fed raised rates by 75 basis points on Wednesday, its biggest increase since 1994, and expectations of more drastic tightening ahead have shaken markets and increased worries over a potential recession.

That echoes concerns of some other investors, who have worried that market conditions could worsen as the world’s largest holder of U.S. government debt reduces its presence in the market.

Wall Street is also pricing in a greater risk of default by major U.S. banks.

Spreads on five-year credit default swaps (CDS) of JP Morgan, Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC) peaked to fresh two-year highs on Thursday.

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Some strategists are concerned that these might point to "stress under the surface".

"The overall underpinnings of the economy are quite shaky," said Ryan Detrick, senior strategist at LPL Financial (NASDAQ:LPLA). "The next six months could be quite perilous."