A View from the Trenches, July 7th, 2009: "Understanding liquidity in 2009"
I am back from a relaxing vacation in the Outerbanks, NC, where the
first heavier-than-air human flight took place (Dec. 17th 1903). Why do
I mention this in a market letter? Visiting the Wright Brothers
National Memorial, you see the proof that fundamental and critical
research and innovation can blossom without bureaucratic supervision.
Indeed, Wilbur and Orville Wright did not care to publish in scientific
journals, write a PhD thesis or ask for government grants. It was all
entrepreneurship, encouraged by an environment of free enterprise.
Having said this, we return to our daily market analysis. In terms of
trends, nothing new happened. As we said a few days ago:
1.-Credit continues to be considered the last line of defense (http://sibileau.com/martin/2009/06/23/).
2.-Equities would first stagnate
(http://sibileau.com/martin/2009/06/03/ ) and later
(http://sibileau.com/martin/2009/06/22/ ), one would do better by
stepping to the sidelines.
3.-Liquidity doesn’t seem to be the problem
(http://sibileau.com/martin/2009/06/24 /). Instead, the problem lies in
the fiscal deficits, which are nothing else than a transfer of
imbalances from the private to the public sector.
Understanding the “evolution” of the liquidity market is critical to
surviving in this crisis. Thus, the chart below has caught my
curiosity. The orange line represents the LIBOR – OIS spread, which is
the difference between the 3-month Libor and the Overnight Index Swap
spread. In other words, the difference between the cost that banks face
to lend to their customers (3-month Libor, which is an indicative,
offered, rate) and the overnight rate (which is an effective, rolling,
rate). Essentially, this spread signals for financial institutions the
cost of “renting” their balance sheet. When liquidity is scarce, this
cost rises. Thus, the relationship between the Libor-OIS spread and the
value of the USD in terms of CAD in September 2008 is self explanatory.
As liquidity disappeared with the fall of Lehman, the USD got very
expensive (Back then, the Fed extended multiple currency swaps to other
central banks, to supply USD to the market). With the intervention of
the Fed, the spread decreased dramatically. As liquidity improved, the
value of the USD began to be driven by fundamentals (fiscal deficits)
rather than the need to repatriate liquidity. Now, since June,
this relationship doesn’t appear to be working. Although 3-mo LIBOR is
at 54.8bps and the Fed Funds (overnight) rate is at 20bps, the USD has
lately appreciated, particularly against commodity currencies, as the
CAD. Some analysts attribute this to a needed “correction” in
commodity currencies, a reality check, in light of confusing activity
data (i.e. unemployment). In my view, this is actually a
LIQUIDITY (financial) problem, not an imbalance (economic) problem. I
believe the liquidity market, as we knew it until November 2008, has
changed. In particular, the break in this relationship may be signaling
a relevant SEGMENTATION/DISLOCATION produced by central bank
intervention. Why should we care? Because if this thesis is correct, if
the sell-off in equities spirals (i.e. fiscal stimulus is not upsized),
the Fed and other central banks will have run out of ammo, leaving
asset deflation as the alternative for stabilization. (Readers’
feedback welcome!)
Source: Bloomberg
(If you wish to subscribe to this daily blog and receive it by email and in pdf format, please go to: www.sibileau.com/martin ...It's free!)