Can't Wait Until 2008

Despite the massive rally in the equity markets over the past two days (rate cut anyone?), the money markets are foretelling a huge liquidity crunch over year-end that is reminiscent of another "crisis".

Today was the first day that 1-month LIBOR extended over year-end, meaning that borrowings based on that index do not need to be repaid until the first business day of 2008. So what happened? EURIBOR jumped 64 basis points and LIBOR rose 40 bps, implying an overnight rate well into the double digits on the last day of 2007.

Not surprising given the liquidity pressures that have rocked the money markets since August, but this move actually pales in comparison to what happened the last time the markets thought the world was coming to an end: the Y2K "crisis".

On November 29, 1999, 1-month LIBOR jumped 87 bps, as there was widespread fear of systematic failure that would make any type of refinancing problematic from a technical perspective. Of course, that fear proved to be unfounded thanks to what turned out to be a sufficient level of preparedness.

Is the same thing going to happen this time? Well, our favorite indicator of market fear/greed has spiked again. but as stated before, the "forward" TED spread is still a lot narrower than the spot spread.

All of which argues that central bank intervention to relieve short-term pressure will (a) be effective and (b) isn't a "bailout" that creates moral hazard. So recent statements (reported by Bloomberg) by the ECB to supply cash "for as long as needed" and by the Fed to "provide sufficient reserves to resist upward pressure" on borrowing costs are on the up and up.

Should be a sober New Year's celebration in Washington and Frankfurt....

Who's Afraid of the TED spread?

A lot has been written recently about the rise in yield of LIBOR, the short-term rate that banks charge each other, even as rates on other short-term fixed income instruments have fallen. Reasons have ranged from impact of the collapse of the asset-backed commerical market to hoarding of cash (and not lending it out) to broader liquidity issues.

One thing that we learned from our fixed income strategist mentor (for me, the great Curtis Shambaugh) is that if you are looking for a reliable barometer of fear and greed, the TED spread is practically unbeatable.

The "T" in TED is the Treasury bill yields, and the "ED" is Eurodollar futures, the way the market trades future 3-month LIBOR settings. Because of their risk-free nature, Treasuries will always yield less than LIBOR, so the wider the spread between the two, the more fear is apparent in the market.

Therefore the spot TED spread is very wide (at a 20-year high according to some), indicating lots of current fear. But the future TED spreads are much narrower, since the T-bill curve is positively sloped (3-month bill yield = 4.07%; 6-month bill yield = 4.20%) but the Eurodollar curve is massively inverted (Sep '07 =5.56%, Dec '07 = 4.76%).

Maybe things aren't going to be so bad after all...