Fed Set To Reveal Poker Hand; LIBOR vs FFR
A: With the fed meeting this week and announcing their next move on Wednesday, plus the first glimpse of Q1 GDP, it seems the fed is set to reveal their hand and let us know if rate cuts are in fact ending soon! The current consensus on the street from people I talk to tends to be a 'one & done' move, with a change in the issued statement. With 3-Mth LIBOR still 65+ basis points above the fed funds rate, we are left to wonder whether the credit crisis is over or just in a the so called 'eye' of the storm.
Lets start with the fed. We will get a glimpse of Q1 advance GDP on Wednesday, before the fed announces their decision; so clearly that information is playing into the next fed move. However, with oil trading at $120/barrel, and other commodity prices surging to the 'weak-dollar' policy we have seen in the past, consensus is for a change in bias! I doubt the fed will disrupt market expectations, so instead of looking at their action (I'm expecting a 1/4 point cut, along with the street's expectation) focus on the issued statement for changes to the following passages from the previous statement:
a) 'inflation has been elevated and some indicators of inflation expectations have risen'
b) 'outlook for economy activity has weakened further'
c) 'financial markets remain under considerable stress'
Personally, I expect an increase focus on inflation and a decrease focus on 'considerable stress' in the financial markets; thinking this way since April 18th when 2YR treasury yields were about to go above the fed funds rate:
"Take a look at the 2-YR treasury yield over the past month (chart on right), up almost 70 basis points. In fact, yields are up across the board for treasuries, as the stock market rallied over 4% this week. The most dramatic action in the bond market was in the short end; 3mth, 6mth, 2yr & 3yr yields causing the so called 'flattening' of the yield curve. This gives investors more incentive to cash out of longer term treasuries, and put that money to work elsewhere (stocks?). It also could be a sign that expectations are rising for less action from our fed, probably resulting from pipeline inflation pressures."It's highly possible the markets rally on a positive fed statement in the sense that considerable stress is no longer seen! Time will tell. Certainly, there are signs of easing in a few sectors of the credit markets. Specifically:
1) spreads in CDX indices have narrowed
2) spreads in CMBX (commercial re mbs) have narrowed
3) investment grade corporate debt spreads narrowed
What isn't improving is:
1) money market rates
2) LIBOR rates
3) ABX indices
These are just a few sectors that I follow and discuss with friends I know on front lines. There are many other areas that I am not as real-time updated on. Lets focus on LIBOR for a moment. LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits. LIBOR is used in determining the price of many other financial derivatives, including interest rate futures, swaps and Eurodollars. So, it's a worthy indicator of stress amongst the banks; are they aggressive or reluctant to lend to each other?
One way we can determine this is by comparing the LIBOR rate to the fed funds rate, and looking at the spread between the two rates. In normal markets, 3-MTH LIBOR is within about 15 basis points, or 0.15%, of the fed funds rate, which currently stands at 2.25% going into Wednesday's meeting! Below is a chart (courtesy of Financials.com) showing you the spread between 3-MTH LIBOR and FFR for the past 30 days; notice the widening of the spread in mid-April!
This is the simplest way to show you, what I like to look at for a glimpse into bank's willingness to lend to each other. Now, there could be a number of reasons for this abnormal spread of about 65 basis points:
1) credit worries remain
2) banks are capital constrained as they correct balance sheets
3) recent concerns about LIBOR reporting
4) expectations of rising fed funds rate in near term
I'm sure there are more. But fact is, this wide spread tells you that banks are still reluctant to lend to each other! It's a signal of continuing distress. Which leaves us wondering, who is right? Is LIBOR lagging and behind the curve in its behavior to narrow closer to the fed funds rate OR is LIBOR leading and telling us that more stress is yet to come in the credit markets?
One thing is for sure, and that is by end of day Wednesday we will know a lot more information regarding our economy, the potential recession's beginning, and what the fed is likely to do with rates over the next few months!
Posted by query1
Mon Apr 28th, 2008 04:02 PM
I admit I sure don't have the answer but I wonder if the NYC real estate market of which Noah is an expert may provide a clue. If it is true that we are in a deleveraging mode, and banks have to delever like everyone else, wouldn't they have to hoard their cash and sell assets at distress prices to cover their reserve requirements until they found opportunities to lend their cash at expected rates of returns that would be high enough to help them meet their reserve requirements without having to keep selling assets at distressed prices? In other words, they are going to have to hoard cash and sell assets until they can make enough out of the cash they can loan. If this is true, what is a good return on cash at this time? I would think the NYC real estate market would provide a clue assuming the high level of interest on the buyers side reflects people with cash for a downpayment. If NYC is becoming a buyers market, what kind of discount off the "par value" are they looking to get? In other words, look at these buyers as delevered bankers. What kind of return are they trying to get on their cash at this time in the form of reduced price off the "par value"? Once that is known, what are the markets banks can lend into that would give that kind of return? Until those are spotted, I would suspect the credit crunch continues.
Posted by Noah
Mon Apr 28th, 2008 11:18 PM
query1 - I just don't know. Its a great question. Let me re-read tomorrow when the drinks wear off.
Posted by jeff
Tue Apr 29th, 2008 01:43 PM
Query1
Banks are definitely hoarding capital until they can replenish reserves. In some cases they are raising capital and saying they are doing it to get out ahead of potential future losses....many investors believe they are raising money to cover over embedded losses they know they are going to have but won't admit to. From the dilutive deals they are doing to get capital, it appears that the latter is true. This is causing spreads on interest earings assets vs. funding costs to widen for those who are still lending. They are borrowing at lower fed funds rates and lending at less competitive higher longer-term rates. In fact competition for CDs...another source of bank funding has come way down in our fair city, as those who are tight on capital and not lending but just investing borrowed short-term money in longer term treasuries are being careful not to pay up for CD money and ruin their spreads. Eventually, the leveraged, spread earning capacity of banks will make up for all their losses...given enough time. The question is how big will the lossses ultimately be and how much will the government subsidize the rebuilding of reserves through vehicles like the term lending funds they have set up.
Posted by query1
Tue Apr 29th, 2008 06:33 PM
Jeff...Thanks for the clear explanation. This helps me understand why many are saying there is a long way to go before the credit crunch is resolved. It looks like they are on the path to 1) cover the losses they identify with write-downs; and 2)produce earnings. But then will come actual losses from defaults in some of what they hold as the real economy continues to slow down, and, I suppose, their earnings will slow too. Then they will have to cover those losses and will have lower earnings while they are doing so. All of this must mean they are a long way from returning to the point where they were an engine of growth for the real economy through their lending practices. That, in turn, would suggest that prices in all markets will have to continue to fall until the future value of what the price reflects can spur on investment and lending for investment.