Macroeconomic investors spend quite a lot of their time looking for leading indicators: variables which can help them predict the evolution of asset prices. A reliable and timely leading indicator of market downturns is the Holy Grail of macro-investing. Judging the quality of those leading indicators is a tricky econometric task (more on this exciting topic in a later blog).
Here I want to focus on recent developments in a candidate stress indicator that rose to prominence during the financial crisis: the LIBOR-OIS spread. It highlights the importance of understanding in detail why leading indicators are moving, rather than just focusing on the headlines.
LIBOR-OIS: what is it?
LIBOR contains substantial default risk; OIS contains very little. The gap between the two is therefore taken as shorthand for the market’s perception of short-term default risk in the banking sector. In 2009, Alan Greenspan referred to this measure as a “barometer of fears of bank insolvency”. Market analysts obsessed about its ebb and flow on a daily basis.
With the LIBOR-OIS spread rising in recent months (see chart below), should the alarm bells be ringing about the banks once again?
Why is it increasing?
In one word: regulation.
The regulatory regime that applies to US money market mutual funds is changing significantly in mid-October. To reduce the risk of a forced liquidation (which we saw in the 2008/9 financial crisis), money market funds investing outside of Government Securities will be required to publishing a floating net asset value (NAV) and impose gates if/when their 'weekly liquid assets' fall below 30%.
This pending change has led to a rush of money from Prime (i.e. commercial paper) into government-only money market funds as those funds will be allowed to continue operating with fixed NAVs. The total assets in Prime money market funds have dropped by nearly $500bn over the last twelve months as a direct result.
The side effect of this change has been an inevitable (and notable) increase in bank funding costs (i.e. higher LIBOR-OIS spreads) that the market expects to be fairly persistent.
The law of unintended consequences
Higher LIBOR-OIS spreads imply that for a given level of interest rates charged by the central bank, the cost of money for the broader economy is now some 10-20bp higher.
There is room for a sensible debate about whether the SEC has done some of the Federal Reserve’s work for them in tightening financial conditions. However, more importantly, recent developments tell us absolutely nothing about market concerns around bank solvency.
It would be a big mistake to take the lessons from the past (i.e. that higher LIBOR-OIS spreads indicate equity market weakness ahead) and apply them blindly to the present without a good understanding of the context.