Libor Once Again Signals Tighter Credit

by: David Enke

Money markets are signaling that recent credit problem may be long from over, with possibly the worst yet to come (see Bloomberg article). As with the end of 2007, interest-rate derivatives are showing hesitation from the markets over fear that credit losses will continue to increase.

The premium banks charge for lending short-term cash is near 77 basis points over what traders predict the Federal Reserve's daily effected federal fund rate will average over the next three months - approaching the record levels set last year and near recent high levels (see recent posts here and here). The spread is up from 24 bps earlier in the year. The spread effectively measures the difference between the three-month Libor and the overnight indexed swap rate and is often used to tell whether or not the markets have returned to normal.

Often a narrowing of 25 bps or less in the Libor-OIS spread is considered positive. Unfortunately, the forward markets do not indicate this happening for nearly two years, around June 2010. Of course, the reliability of Libor has also been in question recently (see previous posts here and here). Nonetheless, the size of the spread still shows a level of fear in the credit markets that may take a while to correct itself as investors wait for the next shoe to drop in the financial stocks.

Disclosure: None