Liquidity or Fear?

Since the money markets imploded in August 2007, players have paid close attention to the Libor-OIS spread, the EUR/USD Basis Swap and associated flattening of Whites-Reds as potential warning signs of stresses in the inter-bank market. In recent weeks, these stresses have become elevated, much to the confusion of many money market traders. Most FX Forward guys report that the minute White Eurodollars get hit, the offer for Dollars in term disappears, as bad memories of late-2008 surface, but simultaneously the Overnight and Tom/Next market is awash with Dollars. It's pretty easy to see that since Ben, Merv and Trichet fired up the printing presses, the global monetary base has exploded. Remember the chart below? That was the one showing that banks are hoarding money rather than lending it out (much to the irritation of many politicians), and that the Monetary Transmission mechanism was broken. Well, maybe it is, but it's hard to argue that banks are having trouble funding when they are sitting on this cash, the day-to-day funding markets have plenty of Dollars and, so far, interest in the Fed/ECB FX Swap lines has been virtually non-existent. Some argue that the rate is uneconomic, but 10-15bps is neither here nor there - if you want USD, you will pay up for them. The lack of participation here is telling...

So is this just fear then? Most of the widening in Libor-OIS has been futures-led in forward space. The below chart shows the Sep10 US FRA/OIS spread having widened 50bps since mid-April. Now, Libor has risen significantly as fears of a European banking crisis, triggered by one or more of the PIGS defaulting, but only by about 30bps. The EUR/USD 3m Cross-Currency Basis Spread has also similarly widened, as players have been reluctant to make markets in term. To some extent, the widening has probably also been driven by unwinds of "Fed on hold" trades, expressed mainly in Eurodollars. Another reason with which to beat them has been a noted US bank research piece suggesting that the financial reforms could add 25bps to the "fair value" for Libor, plus another 100-150bps if EMU breaks up, triggering a European banking crisis. The logic behind the financial reform premia is related to the spreads between CP rates for Financials & those for Industrials, and to some extent, reduced implicit support for the financial system should lead this to rise, but let's face it, whatever the government insist, when the shit hits the fan, they are going to stand behind Citi, BoA etc. So this isn't really likely to have much of an effect on the "fair value" of Libor. And now that the Germans have passed the EU/IMF bailout package, the probability of an EMU break-up-led crisis is very low, at least for the next year or two. So the fear in Libor-OIS looks well-overdone here...

Finally, the recent crisis has triggered a lot of safe haven flows into the Swiss Franc, as well as Hedge Fund attempts to fight the SNB's extraordinary FX intervention. As money has flowed out of Europe and into the CHF, it has driven Swiss implied interest rates sharply negative in the FX Forward market, with the 1M rate trading as low as MINUS 1.3% (see first chart below)! This is even more extreme than the market stresses in Q4-2008. I bet a few players are looking at their carry bill and scratching their heads. Interestingly, this is a gift for the Gold bugs who can now get long of Gold and get POSITIVE CARRY! We are not quite up to the panicked levels of November 2008 when Citigroup was imploded, but we are pretty close (second chart).So what appeared to start as a bounce day, following a healthier close in NY, a relatively positive session in Asia and a return to Summer in London, has gently been destabilising again. And that's without Mangler Merkel throwing any Comment Grenades into the risk room. Hope she has learned the lessons of early-Ben and is keeping schtum.