Krrrrr, Krr, Krr, Krr-chunk… and splosh. Or, the crumbling sound of thawing ice as it detaches itself from the Arctic shelf.
That, at least, is the best way we can describe the sound coming from the Bloomberg machine’s Libor-OIS spread page:
And it’s not just the LIBOR-OIS spread, as the Big Picture blog highlights a similar thaw is transpiring across the Ted spread and 3-month Libor pages too.
As Standard Chartered note (our emphasis):
There are rather consistent signs that the worst in terms of funding market crisis is over. Libor/OIS spreads have steadily contracted, reflecting the combined impact of the recapitalisation of the banking sector, the credit guarantee schemes implemented by some governments and maybe the re-starting of some form of interbank lending among most creditworthy institutions.
Not only have spot Libor/OIS spreads narrowed, but also forward Libor/OIS spreads. There is particular evidence of this phenomenon in the UK, where the Libor/OIS spread curve had been very steep. Finally, bid-to-cover ratios to TAF (term auction facilities) auctions have remained limited, suggesting a re-starting of term interbank lending among banks themselves and/or less “stressed” demand for term funding.
Of course, while that is very good for the front-end of the curve, Standard Chartered do offer one area of concern for the future:
Further on the curve, market expectations are less sanguine and there has been a rather sharp steepening (50bp between December 2008 and May 2009) in the 1y OIS rate, 2 years forward and the 1-year OIS rate, 1 year forward. By contrast, the spread between the 1-year, 1 year forward and the 1-year spot OIS rate has remained pretty constant.
In other words, the assumption of low base rates for at least two years is hardly challenged, yet the amount of tightening priced in past these two years has increased. This pricing assumption might be challenged in our view if the situation of the financial sector continues to strengthen and given the mechanical tightening of the theoretical rule-based rate. We would see such a challenge as a major flattening factor, probably accompanied by slightly higher level of rates.
What’s more:
A situation might however arise whereby the Federal Reserve stance becomes very accommodative because it just cannot recover control over the Federal Funds rate; we have indeed previously underlined that the distance between the effective Federal Funds rate and the target rate had been very volatile and negative during the last steps of the current accommodation, implying that excess reserves were creating an incentive for effective fed funds lower than the base.
Which, essentially can be taken to mean that massive QE has made money free. Accordingly, the big question now is just how will the Fed make the Fed Funds rate a serious number again, and — perhaps more importantly — what happens when they do?
According to Standard Chartered:
The Federal Reserve has a tool to change this situation, however, through the use of the newly created deposit rate on reserves (6 October 2008). The rate paid on excess balances was set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.
The formula for this rate was updated on 22 October: Under the new formula, the rate on excess balances was set equal to the lowest FOMC target rate in effect during the reserve maintenance period less 35 basis points. It was updated again on 5 November: the rate on excess balances was then set equal to the lowest FOMC target rate in effect during the reserve maintenance period.
It was updated again in December and fixed at 0.25%. Obviously a higher deposit rate would limit the incentive to lend excess balances outside the system, so could provide the Federal Reserve with an effective tool to rapidly limit the impact of high reserves — we would closely monitor developments on this front and would expect changes to the formula for the deposit rate to maybe precede any tightening of the policy in the medium run.
Related links:
All about exit strategies now – FT Alphaville
Down yields down! – FT Alphaville
What price risk? - FT Alphaville