Interbank Lending Strains Force Central Bank Action

by: Todd Campbell

Wednesday's coordinated Central Bank move to unlock dollar funding markets was forced by continuing fear of counterparty default. Interbank lending markets continued to show strain throughout the October rally and measures came to a head Tuesday, prompting Central Banks to drop costs on dollar funding to 50bps from 100 bps above the overnight index swap ("OIS").

The Libor OIS spread has been a great measure of interbank fear. As the sovereigns wrestle with austerity, banks are shoring up balance sheets. This has created a hoarding mentality at highly leveraged European banks. Instead of providing fuel in the form of liquidity, they've been stockpiling to avoid getting caught on the wrong side of a bank failure.

The imminent failure of a major European financial institution, likely one heavily exposed to dollar denominated risk, is likely behind the Central Banks move today. Unfortunately, the policy change does little to change the underlying risk to these banks.

Opening the spigot staves off a imminent failure. But, without a corresponding drop in funding costs and a return of market participants, any rally will be short lived.

So, how did the Libor OIS spread react in the wake of the announcement? Much like the announced expansion of currency swaps in September 2008, following Lehman's collapse, interbank market showed little easing. The Libor OIS spread moved higher on the news, hitting 42 bps and reaching its highest since 2009. Similarly, the TED spread - another measure of interbank fear -hit new highs above 52. In the short term, the actions have done little to ease tension.

Most likely, we'll remain in a period of tiered credit costs. The strongest players will continue to get the best rates. The weakest players will struggle.

The saving grace comes if sovereign debt markets begin to rally, driving yields back down to manageable levels. Italy's yields came down a bit today but stubbornly remain above 7%. France's yields dropped back below 3.50%. And, Germany's rates were unchanged. Absent follow through, markets will roll back over as nationalization risk mounts.

Investors will also be well served to pay particular attention to the level of deposits European banks are parking at the ECB overnight. Levels have steadily moved higher since Q3 as banks avoid risk. At 300 billion Euros parked overnight Tuesday, levels remain nearly 200 billion Euros above normal. Banks also have increasingly tapped the ECB's weekly funding spigot. The 265.5 billion Euros provided to 192 banks this week was up from 247 billion Euros and 178 banks last week. The ECB has become the only game in town, and that's evidenced by its balance sheet, which has expanded to record highs.

So, while gains this week provide some psychological relief, interbank lending markets are still telling you to fade the rally. If you don't, you run the risk of getting caught flat-footed by overnight news of a bank failure or nationalization.

Note: Investors looking for a refresher on the role of swaps in the 2008-2009 recession can view a New York Fed report by clicking here (.pdf).

Disclosure: I am long SDS, QID, UUP, DRR.