Wednesday, September 24, 2008

This is bad: Libor at a new high

Substantial strains continue to exist in the money market, as evidenced by Libor and T-bill rates. Today, three-month Libor was set at 3.476%, up a whopping 26.5 basis points on the day and the widest spread to the fed funds target since 1987. The yield spread had been around 80 basis points for months before this latest hiccup (a "normal" spread would be closer to 12.5-25.0 basis points). Three-month T-bills are trading at 0.42%, down 28 basis points on the day.

Some of the strain in the money market undoubtedly reflects the forthcoming quarter-end, which is boosting demand for the most liquid assets, from Treasury bills to cash. There are also pressures from Japan, which faces its fiscal half-year end, an event that even in normal times results in a repatriation of capital into Japan. Uncertainties over the U.S. plan to purchase distressed assets are of course contributing to the money market problem, not only on an institutional level, but on a retail level, as the proliferation of news on the plan is affecting the mood on Main Street.

A pattern is developing that deserves repeating: LIBOR, the TED spread and other fear gauges have historically taken time -- at least two to three months -- before settling down after previous financial shocks. Such was the case following the demise of Long Term Capital Management and Russia's default in 1998, and after the 1987 stock market crash. It is only human nature for frayed nerves to take time to settle down.

The key to whether it does is foreign involvement in U.S. markets, which is vital to financing both the government's initial outlay (the $700 billion price tag massively overstates the actual price tag, because the government is buying distressed assets at equally distressed prices; the U.S. could turn a profit) and its annual deficits. No new ground has been broken in the dollar, and I do not expect that that will happen for many reasons, although confidence is an unpredictable variable, as many financial companies have found out this year.

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