(from our Tactical report of 26th July)

One of the early warning signs of the 2008 crisis was the widening in credit spreads such as the Ted spread and the Libor-OIS spread.  There was a run on the shadow banking system as the credit-worthiness of many financial institutions came under suspicion in the wake of the housing crisis.  Banks’ traditional forms of short-term funding such as certificates of deposit (CD) and commercial paper (CP) dried up.  As a result Libor, which is supposed to reflect bank funding costs, began to rise inexorably.

img1Source: Macrobond, Bloomberg and Variant Perception

Today, we are seeing some widening in the Ted spread (red line, chart below) – but for what should be predictable reasons.  More onerous regulations, which are due to come into effect on October 14th, are leading to less demand for so-called prime money market funds.  Given that they invest about 60% of their assets in CD and CP, this is causing bank funding costs to rise, and so Libor has been rising.  The Libor-OIS spread has been widening (black line, chart below), which is reflective of tougher bank funding, but does not necessarily imply a bank-funding crisis is on the cards as this new regulation has been known about for some time.  However, should Libor-OIS not stabilize then this would indicate a potential bigger problem.  The Ted spread should also widen more over the next few months as money moves from prime funds to government funds, which implies higher Libor and lower UST bill yields.

img2Source: Macrobond, Bloomberg and Variant Perception