On Monday morning, the Federal Reserve announced intentions to extend temporary USD liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank through February 1, 2013. In addition to expanding the length of the program, the rate on such arrangements was reduced (from the overnight indexed swap rate + 100 bps to OIS + 50 bps). Further, swap facilities will be made available in non-USD currencies.
An indicated intention of such measures is to extend USD-denominated liquidity to global short-term funding markets in an effort to avert a disruption in U.S. financial conditions. Given the widening of LIBOR—OIS spreads this year, concern on the part of central bank authorities appears justified. Exhibit 1 below shows 3-month USD LIBOR minus 3-month OIS for the last six years (on a weekly basis), along with labels that indicate news events that corresponded with spikes through the apex of the crisis. Notice that pre-2007, the difference between LIBOR and OIS generally hovered around the 10 bps marker. (Recall that the LIBOR—OIS spread is “a barometer of fear of bank insolvency”, in the words of former Fed Chief, Alan Greenspan. Click this link for a more detailed explanation of this measure.) By the worst point of the crisis, this indicator exceeded 365 bps. Over the course of the next several quarters though, LIBOR—OIS gradually reverted back to normal levels. The growth scare of 2010 induced another sudden round of interbank fear, but these concerns were apparently allayed relatively quickly, as the LIBOR—OIS spread fell back yet again to the 11-12 bps range by late August 2010. Since that point however, this meter has risen fairly consistently. Moreover, the velocity of the increase has accelerated over the past few months.
Of note, I think that media coverage of this event may have skewed equity investors’ understanding. Thus, I think it important to point out that this news does not constitute innovative action on the part of the central banks around the world. As Steven Hochberg, Editor of The Elliott Wave International Financial Forecast: Short-Term Update, and Cullen Roche, founder of Pragmatic Capitalism (see Swap Lines—Not a Panacea), have pointed out, USD liquidity swap facilities were implemented most recently about four years ago, on December 12, 2007 (see Central Bank Liquidity Swap Lines for more information on this mechanism). The first iteration expired on February 1, 2010 but round two was implemented in May 2010 in response to resurging funding market pressures.
Another noteworthy point: liquidity swaps have not necessarily been an enduring stimulant for equity markets. Notice in Exhibit 3 that most of the bloodletting of 2008 unfolded well after liquidity swaps were implemented. In fact, a mild market decline was the immediate response to the revival of this agenda in the Spring of 2010. Of course, following the pullback during the summer of last year, equities ultimately powered higher to new post-crisis peaks. Nonetheless, this mixed historical track record, at the very least, calls into question any expectation that the most recent extension and cost reduction will reinvigorate risk asset markets for any reasonable length of time.
In fact, there is already evidence that some non-equity financial markets are dubious of stocks advance this week. For instance, while the S&P 500 gained 2.9% on Monday, 10-year Treasury yields closed slightly down on the day—in fairness, this observation did precede the Fed’s big announcement. Moreover though, on today’s trading equities were up as much as 1.2%, and remained in the green until the last 15 minutes of the session. The 10-year Treasury yield, on the other hand, spent only a bit more than the first hour of today’s trading above yesterday’s close. Yields then deteriorated rather consistently into the last hour and a half of trading before finally firming (10-year yields closed over 3.5% relative to yesterday’s last print).
Thus, while I acknowledge that the reduced costs and extension of liquidity swaps could potentially serve as a shot in the arm for sentiment, and thereby extend the run-up equities enjoyed this week (Wednesday’s stock price action makes this perspective quite obvious), I have my doubts that this move can/will support equity markets for any protracted period of time. Multiple degrees of momentum supportive of spread compression keep me fairly open-minded on this point, however. Given the approximate coincidence between equity market bottoms and peaks in LIBOR—OIS spreads, I recommend monitoring this measure (and/or other barometers of interbank stress, such as the TED spread) for some indication as to whether the swap facilities engender optimism in the interbank lending.