The Libor-OIS spread is the metric the Fed uses to capture the perception of risk in the credit markets. It measures the premium on the dollar interbank lending rate over the US dollar overnight swaps, which capture central bank interest-rate risk.
Back in August/September last year, when the Libor-OIS spread first blew out, everyone was saying what a freak event it was. Judging from the spike this September, not so much.
Indeed, if you look to the bottom right of this screenshot, you can see a normal distribution of Libor-OIS spreads, and whereabouts on that curve our current predicament is. Pretty far out.
In fact, the current spike is a 6.2 sigma event, based on historical observations of the Libor/OIS to 2001. That is to say, 6.2 times the standard deviation of Libor-OIS spreads from their historic mean.
A six sigma event has a 0.00004 per cent probability of occurrence. On a daily basis, six sigmas should occur every 6800 years. Which is actually an improvement. In October last year, when the spread first blew out, the movement was a 9.7 sigma event. Conclusion: normal distributions are no good for predicting market events.
So what is going on? Dollar Libor has rocketed. Banks are not lending to each other. All very troubling in light of the bailout plan, the express purpose of which is to solve this very issue. Forget how stock markets react to the bailout plan, this is the market that matters. There isn’t a bean of confidence in sight.
So how are banks funding their overnight operations? Well, they’ve become dependent on central bank money for starters. Rather than ease banks’ liquidity fears with each other, central banks’ money market operations have simply fostered a narrow minded dependence.
Central bank money has limits though. Most auctions have been oversubsribed, so banks have been turning back to commcercial paper issuance to try and solve overnight funding worries. The dollar volume of AA rated financial CP issued jumped from $7.2bn on Sep 19th to $14.6bn on Sep 22nd, all of which is for the very shortest maturities of between 1 and 4 days.
Which again cuts back to the criticality of the money market funds buying that CP. If outstanding CP continues to fall, and CP yields continue to rise, the remaining lifeline will slowly be turned off. With luck, we’re in the darkest hours before the dawn. It all rather hinges on that bailout plan. And of course, whether more banks will fail. WaMu being the one to watch.
Update. Spotted this on the WSJ website. Are banks underestimating Libor? (Favorite trope of the WSJ this).
…on Monday, the rate for the 28-day Fed facility was 3.75%, which was much higher than Libor. On Monday, the one-month dollar Libor rate was 3.19% while Tuesday’s rate was 3.21%.
The Fed’s lending is secured by collateral, so the rate should be lower than Libor, which is unsecured. The discepancy may have something to do with the fact that the Term Auction Facility was oversubsribed: $133.5bn of bids were submitted in Monday’s auction, but only $75bn was available.
Update 2. As spotted by sharp commenters below, todays Libor-OIS spread has widened to 197bps. If you have Bloomberg, check out the graph. Code is: USSOC US0003M HS
