The financial market may cross a zone of turbulence
THERE IS one important number that, in our opinion, has not received adequate attention, the “Spread between short-term London Interbank Offered Rate or LIBOR and Overnight Indexed Swap (OIS) rate”.
This figure is important because it could reflect a current state of liquidity in the market, especially the dollar liquidity and risks within credit markets. Interestingly, whenever this spread surges significantly, it meant financial crisis is already boiling.
London Interbank Offered Rate or LIBOR is a benchmark interest rate that banks charge each other in the interbank market. It could reflect concerns over solvency of counterparty banks or perceived credit risks as well as liquidity risk. If banks expect higher risk, eg during times of financial turmoil, they would lend less and charge higher rate.
However, LIBOR also moves closely with Federal Fund Rate, therefore, to gauge the risk using LIBOR, the effect from central bank’s monetary policy must be excluded. One interest rate becomes quite handy for this task is Overnight Indexed Swap (OIS) rate as it tends to move in tandem with the expectation of Fed’s interest rate.
That is why LIBOR-OIS spread is regarded by many people, including former Fed chairman Alan Greenspan, as a strong and critical measure for stress in the market. For instance, a high spread could imply deteriorated willingness to lend by financial institutions and a state of liquidity shortage. While, a lower spread could indicate higher liquidity in the market and less concerns over creditworthiness of financial institutions.
In the past, rising Libor-OIS spread like the 3-month Libor-OIS spread did a good job at signaling problems in the financial world or even a financial crisis. The best example would be the great financial crisis in 2008 when the spread surges from typical level around 10 basis points or 0.1 per cent to around 364 basis point or 3.64 per cent at the height of the crisis in October 2008, indicating a severe credit crunch in the history.
So what the spread looks like now? The answer may be quite alarming as the spread continued to widen from about 25 basis point which is the median of the spread since 2002 to almost 60 basis point, an unprecedentedly high level since the great financial crisis. Nonetheless, the recent spike is probably not indicating distress in the banking system. The spike, however; is influenced by the Fed’s unwinding balance sheet, torrent of US treasury bill supply, and repatriation tax, which cause the rapidly-rising LIBOR.
As the Fed keep tightening their monetary policy by raising interest rate, they also started to shrink their massive $4.4 trillion balance sheet which means there will be less liquidity in the financial system. Moreover, the US debt market will lose supports from the Fed which kept buying US bonds or asset-backed securities since the financial crisis. Hence, a lack of big buyers would then force short-term rates higher.
On top of that, the market are also facing streams of US treasury bill issuances after the US government finally moved on with their budget with massive spending plan. Flooding debt sales from the US treasury will drive borrowing costs not only for the US government but also other borrowers in the short-term market as well. Furthermore, with the US tax reforms which incentivise US corporations to bring money back to the US, these firms will demand more dollars in the market while off-load short-term instruments like commercial and bank papers that they previously kept their money at. And less demands for these products will also boost borrowing costs.
Therefore, the current rapid rises in the short-term interest rate and the Libor-OIS spread may not hint at roaring credit risks in the market.
Even though, the recent surges in the Libor-OIS spread were not showing signs of stress in the market, the borrowing costs are definitely increasing to the level that are much higher from the post-crisis era. It is critically important for firms, especially those highly-leveraged to realise and be prepared for the environment with higher cost of borrowing in US dollar.
Views expressed in this article are those of the author and not necessarily of TMB Bank or its executives.
Contributed by DUANGRAT PRAJAKSILPTHAI and POON PANICHPIBOOL, specialists at TMB Analytics . They can be reached at [email protected]
