Category — LIBOR

What will 2009 look like? This blog offers key spreads to examine routinely for signs of economic recovery. In chronological order

• The Fed Funds Effective vs. Target Spreads.
• The TED Spread
• LIBOR vs. Investment Grade Bonds

Fed Funds Spread

The Fed Funds Spread, the difference between the “Target Rate” and the “Effective Rate” for Federal Funds is essentially the measure of slack in the economy. Today, the Target Rate is set to 0.25% and the “Effective Rate” for overnight funds trades at 0.11%: banks can not find enough opportunities (or see too much risk) to lend. Instead, banks choose to keep excess funds within the Federal Reserve.

This is the first spread to watch. When the “effective rate” trades at the “target rate”, the economy is performing to its potential in the current interest rate environment.

The TED Spread

The TED Spread, the difference between three month LIBOR and three month US Treasuries, is essentially the measure of trust between the private and public sector. According to the Financial Times, three month LIBOR trades at 1.47%. Three-month Treasuries trade at 0.0014% (zero). That’s a big spread.

This spread can not converge until overnight LIBOR -which mirrors the Fed Funds “effective rate” - trades at the Fed Funds Target rate: Effective Rate vs. Target Rate convergence implies upward pressure on treasury yields, making overnight treasuries trade at a minimum of 0.0025%.  This is the start to redeeming trust in the private sector vs. the public sector.

LIBOR vs. Investment Grade Bonds

This spread measures competition and confidence in the private sector’s ability to earn income. Today, one year LIBOR trades at 2.09%. Reviewing Global Investment Grade Bonds from the Financial Times, most trade at ~6.00% yield.

global-investment-grade

This is the final spread that will show uptick in the economy. When this spread converges, trust in corporate earnings is restored: the public market respects corporate earnings enough to offer a suitable substitute to banks as a source of debt funding.

The LM Curve as Perspective

Reviewing the LM curve, demand for money equals the supply money at a given output and interest rate - in this case a zero interest rate environment.  Output could increase in a zero interest rate environment, with expansion of the money supply (as the Fed is currently doing) and with expansion of the government spending (as Obama is planning). Given we are in a contractionary economic environment, one could argue the US has only slid down the LM curve - money supply expansion has not worked -, awaiting a shift in the IS curve with new fiscal expansion.

However, a healthy economy has demand for money at positive rates. For this we look to the convergence of the spreads listed above.

The Fed Open Market Committee recently announced the extension of its December policy meeting from one to two days. With extra time, I argue the Fed should strongly consider cutting the target Federal Funds rate from 100 basis points (where it currently stands) to 25 basis points.

• As I predicted in Note Twelve, overnight LIBOR has converged upward, reaching the target Federal Funds rate of 1.00%. This is because the Federal Reserve now pays interest on all “excess reserves” banks now park at the Fed.
• A look at TIPS vs. Treasury Yields over the next year still shows wild expectations of deflation. Ergo, even though banks’ excess reserves receive a measly 1.00% by doing nothing, they make larger returns in this environment.
• Though the Fed is paying the target rate for excess reserves, the effective Federal Funds rate still trades at 59 basis points, according to the Financial Times. This is because our Government Sponsored Entities can not receive interest from the Fed on their parked capital. With no bank wanting to use their funds, the Federal Funds effective rate declines further from the target rate.

Most “Fed Watchers” expect a 50 basis point cut in December. As you can see, we are already there. A further cut of this magnitude are moot.

A semi-coordinated solution:

Between the Fed’s recent program and the Treasury’s TARP program, we are going to “borrow and spend” (or print and spend) a further 10% of GDP on “unclogging the system”.

• The TARP program should be injecting enough preferred equity capital to improve bank balance sheets. Yet lending has not picked up, as I argued in Note Twelve.
• I believe the new Fed program should help eventually reduce excess Government Sponsored Entity capital sitting at the Fed by buying mortgage backed securities guarantied by Fannie and Freddie. But it is too soon to tell.

Therefore, the FOMC needs to triangulate a strong signal, telling the banks what all pundits, bloggers, and congressional representatives have been saying for some time:

“Get your capital out of my bank and start lending!”

At 50 basis points, I have argued we would see no change from the current situation. Cutting the Federal Funds rate to 25 basis points should hopefully force a change in bank behavior. Fed rates would just be too low, even with deflation expectations, for opportunities not to be exciting. With it should force excess reserves out of the Fed and back into the the market at essentially risk-less rates.

Cut the rate to 25 basis points and Happy Holidays!

On a randomly selected May 16th, 2007, the Federal Funds rate was 5.25%. The effective rate (the rate bankers actually trade and negotiate at) was 5.29%. The actions taken by the Fed ensured its “target base rate” was the actual base rate for charged money. In short, this is our monetary system we take for granted, daily.

Before the credit crisis, how did the Fed ensure the spread between the target and effective rate stay so close to zero (if you know this, please skip down)?

• Banks are required to hold a certain amount of capital at the Federal Reserve. Prior to the crisis, a banking business model was to lend to outside parties. When lending exceeded required capital reserved at the Fed, banks had to borrow to repatriate to the Fed.
• The first choice of funds to borrow is capital held by other banks at the Federal Reserve.
• Should other banks charge too much for these funds, banks seeking capital could simply short treasuries.
• The Fed would mimicked this action,  buying and selling treasuries to ensure the market price for treasuries kept banks honest in pricing overnight lending.
• Sure enough, on May 16th, 2007, overnight LIBOR was 5.30%, one basis point from the effective rate and five basis points from the target rate.

Today, the story is quite different. The Federal Reserve’s target Federal Funds rate is 1.00%. The effective rate, (from the Financial Times), is 0.49%.

Two implications:

• Almost everyone surveyed, interviewed, and opining (including me) expects the Federal Reserve to slash the target rate from 1.00% to 0.50% in December. That decision is now moot.
• When the effective rate is nearly half the target rate and overnight LIBOR is 0.70%, in between the two rates, and yields on treasuries expiring on November 30th are 2.67%, there is a problem of illiquid markets, not responding correctly to simple centralized decisions attempting to steer the economy. To quote Senator Trent Lott, we are now “herding cats“.

How and why?

Reviewing the minutes from the last Federal Open Market Committee meeting and events of the “credit crisis” I find several issues:

• Randomly sampling daily market rates, the spread between target and effective rates was not large enough to be significant until after the bankruptcy of Lehman Brothers, on September 15th, 2008.
• By September 22nd, 2008, while the target rate was still 2.00%, the effective rate was 1.79%. By the end of that week, the effective rate was 1.21%. In short, capital required to be in the Fed was not going anywhere: thus the start of banks truly refusing to lend.
• So, the Fed on October 6th, 2008 started paying interest on held capital, attempting to establish a floor on effective rates. Most important, the Fed started to pay interest on excess cash held above any requirements.
• But by October 10th, 2008, the policy wasn’t working. While the Fed slashed rates from 2.00% to 1.50%, the effective rate was 0.90%.
• By October 21st, the effective rate hovered below the floor rate established by the Fed on October 6th, 0.73%.
• So, the Fed again in two different announcements, the latest on November 5th, raised the interest rates paid on excess balances. As of today, any excess capital receives the target rate.

We’re still in the same position and I highlight what is explained beautifully in a recent Financial Times article:

• Most of today’s spread is explained because our Government Sponsored Entities, Fannie Mae and Freddie Mac, hold reserves at the Fed. Yet they can not receive interest payments, and thus must lend their capital at the effective rate.
• As banks are queasy regarding their own reserve requirements, they do not want to borrow entity funds for opportunities.  This capital simply sits at the Federal Reserve, depressing the target rate.

The Bottom Line:

• BANKS ARE NOT LENDING. If Banks were lending, there would be no need to pay interest on excess reserves.  That capital would be privately lent, to businesses large and small, old and new.

The Fed now has de-facto set a larger reserve requirement for banks, by paying interest on excess reserves. This is very dangerous.  That excess cash that should be in the market, growing our economy. (As I heard in business school again and again “putting capital to work”).

While overnight LIBOR has trended up since the Fed’s latest announcement (from 0.33% to 0.70% and most likely will continue up to 1.00%), the larger problem is this: For growth opportunities of the US Economy, the same target rate on a larger reserve pool of capital is equivalent to a higher rate on the official “reserve requirements”.

Therefore, when the Fed does cut rates to 50 basis points, what effect will it have?

Since the bailout was enacted, three-month LIBOR declined from highs of 4.75% to 3.52%. Further, three-month LIBOR dropped 90 basis points in this last week.

Room to drop?

The market votes yes. Three-month Eurodollar contracts closing in December (the three-month LIBOR futures rate) is pricing at 2.63%. By June, three-month LIBOR is expected to decline to 2.48%.

Context on the market prediction is critical. We must understand how much risk is priced into spreads.

TED Spreads, the base spread of risk between private capital and riskless funds, remain large.

• Today, three month treasuries yield .93%.
• Investing in treasuries today for returns in March 31st, 2009 yields 1.2125%.
• The implied treasury yield matching the Dec EuroDollar Contract is therefore .72%.
• Further, for three month March LIBOR, projected at 2.50%, equivalent three month Treasuries yield .22%.

So, good news and bad news. LIBOR is declining, but the TED spread remains wide.

As a side note, it is now obvious that Treasury Yields have priced a massive rate cut over the coming months.

Since the First Note, The Government’s Credit Committee, with members Barney Frank, Chris Dodd, and Richard Shelby took more time to get comfortable with Hank Paulson’s proposal.

While the debate in Washington raged on, one month LIBOR increased from 3.19% to 3.70%. Three month LIBOR increased from 3.21% to 3.76%. Commercial Paper increased from 2.50% to 2.70%. Letter of Credit facilities are not expanding. Essentially the way balance sheets are funded is grinding to a halt.

So, how could most corporations raise capital faced with this problem? One answer would be to short treasury securities of the same duration. Simply borrowing the securities, selling them into the market for cash, with the promise to deliver those securities later would do the job.

And why not? Treasury securities expiring on Dec 31 are yielding a paltry 1.02%. Treasury securities expiring on Dec 15 are yielding .68%. Would a betting man believe yields would increase or decrease in the next week? Considering inflation increased over the past year and that the US will sell an additional $700 Billion of debt into the market, yields will most certainly rise.

So, given the demand to short and the rational argument that yields will increase, the fact that the spread is so significant is in fact very significant. Money that normally would buy commercial paper and be infused into interbank offerings is now moving to “quality”. That quality is the United States government backed bonds and notes.

We can quickly examine the balance sheet and income statement of the US Government to know the following:

1. Liabilities just increased by close to $1 trillion, including Fannie Mae, Freddie Mac, AIG and the proposed bailout.
2. Projected top line tax revenue is expected to decline as housing values sink and oil relief is still far off.
3. Inflation is still a huge risk.

So how is this quality? The simple answer is that it is not. And if the US Government is not quality, then imagine how much mistrust is in the private market right now. And this is exactly why those shorting trades are not occurring and not helping to re-balance the spread, lowering TED.

For all of 2008 until now, we heard and read the financial sector was amuck, but corporate American remained strong. Yet now, we are conceivably in a macro-economic death-spiral.

1. If companies continue to be faced with high interest rates and refusal of credit, they will stop expanding.
2. Further, for all those companies who did not hedge exposure (and with lack of quality counter-parties, it is conceivable this is a lot), they will be forced to pay higher rates of interest now on all existing loans and notes.
3. To meet higher rates, companies will have to cut expenses, essentially wages. Reductions of wages will depress the economy further.
4. Consumer spending will continue to decline, making more companies unable to meet existing obligations.
5. Credit spreads will increase for fear of company credit and the cycle will continue.

This week will be as wild as the last one….

Secretary of the Treasury Henry Paulson aka Hank, AKA King Henry, the former chairman of Goldman Sachs appeared on Meet the Press this Sunday. He said “Last week there were times when the capital markets or credit markets were frozen.”

Was he lying?

No. Hank was telling the truth.

Let’s look at markets for short term money. Why? When prices for short term money move, prices for other money must concurrently move. Starting on Monday, September 15^th, when Lehman Brothers, an investment bank, declared bankruptcy, one month LIBOR rates for money were 2.49%. Essentially, the base opportunity cost of private investing for one month was 2.49% on an annualized basis. While the S&P 500 and Dow Jones Industrial Index swooned wildly, one month LIBOR ticked up every day, closing on Friday at 3.19%. In other words, the private sector opportunity cost of efficient investment swooned by 33% in five business days.

Why? Did inflation increase? Did oil prices increase? No. None of this occurred. What did occur was the increased need for cash on banks’ balance sheets. Faced with dramatic uncertainty answering questions such as :

• what do we own? and
• what do our competitors own?

The best answer every bank came to was “don’t loan and keep cash for our own security”.

But it wasn’t just LIBOR that increased ….

Short term 30-Day Commercial Paper, the basic note that keeps corporation engines oiled increased from 2.2 to 2.5%. And to show how much the average American did not trust the solvency of the banks (rightly so if all their business model is now preserving cash and not efficiently loaning cash), One Month Certificate of Deposits increased from 2.51% to 5.0% in the same span of days this week. In other words, if you – dear reader - had a goal of opening a CD last Monday, got sick, and went to the bank on Friday, your rate of return would have doubled.

Is this unheard of?

I think so. If we examine the changes in the same rates from randomly June 4 to June 8, 2007 there was no change in LIBOR rates. If we examine the same rates randomly from July 16 to July 20, 2007 again, no change again. LIBOR held steady at 5.32%. What was the Fed Funds discount rate then? 5.25%. Historically, this has been the case: a strong convergence of the two rates.

What was the Fed Funds rate this week? 2.00%.

Let’s take a deep breath: 3.19% one month LIBOR vs. 2.00% Fed Funds Target Rate means private sector’s unease forced efficient private sector rates north of 50% above the “discount rate”. Given this over 100 basis point difference in discount rate money vs. private credit, Hank was most certainly telling the truth.

What could be next?

This week will be as wild as last week.