Sunday, November 02, 2008

Money market conditions

In the last few months the Federal Reserve and other central banks have tried to ease money market conditions by lowering interest rates. Every country in the world is on an interest rates cutting spree.

This table shows the recent moves of major central banks.

TED spread has been seen as an important indicator of money market liquidity conditions. There is another important indicator which can reflect the liquidity conditions in interbank market. The LIBOR-OIS spread. One of the recent Fed article explains -

The LIBOR-OIS spread has been a closely watched barometer of distress in money markets for more than a year. The 3-month London Interbank Offered Rate(LIBOR) is the interest rate at which banks borrow unsecured funds from other banks in the London wholesale money market for a period of 3 months. Alternatively, if a bank enters into an overnight indexed swap (OIS), it is entitled to receive a fixed
rate of interest on a notional amount called the OIS rate. In exchange, the bank agrees to pay a (compound) interest payment on the notional amount to be determined by a reference floating rate (in the United States, this is the effective federal
funds rate) to the counter party at maturity. For example, suppose the 3-month OIS rate is 2 percent. If the geometric average of the annualized effective federal funds rate for the 3-month period is 1.91 percent, there will be a net cash inflow
of $2,250 on a principal amount of $10 million [(2 percent –1.91 percent) × 3/12 × $10 million = $2,250] to the bank from its counter party.

A bank borrowing at the 3-month LIBOR rate of 2.10 percent that enters into a swap to receive at the 3-month OIS rate of 2 percent has a borrowing cost equal to the effective federal funds rate plus 10 basis points. Entering into the OIS exposes the bank to future fluctuations in the reference rate. However, the bank can guarantee
itself longer-term funding while still paying close to the overnight rate. Because the alternative would be rolling over the funds on a daily basis at changing overnight rates, banks are willing to pay a premium. This is reflected in the LIBOR-OIS spread (defined as the difference between the LIBOR rate and the OIS rate) shown in the chart.

In times of stress, the LIBOR, referencing a cash instrument, reflects both credit and liquidity risk,1 but the OIS has little exposure to default risk because these contracts do not involve any initial cash flows. The OIS rate is therefore an accurate measure of investor expectations of the effective federal funds rate (and hence the Fed’s target) over the term of the swap, whereas LIBOR reflects credit risk and the expectation on future over night rates.

Now, the US Federal Reserve has been able to correct the yield curve by bringing the near term interest rates down. This has been achieved by lowering the Fed Funds rates but it has not been able to reduce the strain on the illiquid money markets.

US T bills have seen record inflow as investors preferred US T bills for safety of investments. Secondary market rates for T bills in US has gone below 60 year low. Have a look

As and when the interbank markets return to normal liquidity conditions there would be a huge inflow of money into other asset classes.

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