With its decision cut interest rates to 0% to 0.25%, the Federal Reserve effectively announced that it now understands the scope and magnitude of the current credit and economy crisis.
Before the recent credit crunch (that is, before 2006), most equity traders couldn't have cared less how a rising TED spread might affect the equity markets or how a drop in the Baltic Dry Index might affect global growth ahead.
But with the Fed now injecting trillions of dollars into the capital markets via various term-action facilities, it’s very important for market traders and observers to follow how broader credit indicators are faring and what they might be suggesting in terms of equity revaluation.
Ted Spread: The TED spread reflects the difference in yield (and therefore risk) between Interbank and U.S government loans. As of Dec. 31, it was trading at 1.35; right after the collapse of Lehman Brothers, it was trading above 4. Historically, these moves are unheard of, but the good news here is that spread has narrowed substantially from its peak, suggesting that much-needed liquidity is now entering various markets. Historically, a rising TED spread often foretells a downturn in the U.S. stock market as liquidity is being withdrawn by investors. Conversely, if we see a drop in the TED spread, this may foretell a rise in equity prices worldwide.
LIBOR: The London Interbank Offered Rate is an interest rate at which banks can borrow funds from other banks in the London Interbank market. LIBOR is fixed on a daily basis by the British Bankers' Association. It is one of the most important indicators because it measures the rate at which the world’s most-preferred borrowers are able to borrow money. If LIBOR rates are high, then downward pressure on equity prices is likely. Likewise, if LIBOR rates are low, then upward pressure on equity prices is likely.
One year ago, one-month LIBOR was 4.6; currently it is 0.4. This means the cost of borrowing capital overnight from bank to bank has decreased dramatically. A year ago, three-month LIBOR was 4.7; currently it is 1.4. It is clear from looking at a monthly trend of LIBOR that systemic risk in terms of a bank or even a country failing has been removed from the capital markets. Ultimately, this is a positive for financial companies as a whole and particularly for companies such as Citigroup (C), Goldman Sachs (GS), Bank of America (BAC) and Wells Fargo (WFC) whose short-term costs of capital have decreased substantially even over the past month. Lower overnight borrowing rates should equate to high profit margins
LIBOR OIS: The LIBOR OIS spread is the London Interbank Offered Rate over the overnight swap spreads; in essence, it measures the cash scarcity among banks. Former Federal Reserve Chairman Alan Greenspan once called this one of his favorite gauges. It has narrowed substantially over the past several months
Baltic Dry Index: The Baltic Dry Index is an assessment of the price of moving the major raw materials by sea. Basically, the index signals how global trade and growth is currently faring. If spot rates are very high, we can assume that the global demand for commodity-related products is also robust, suggesting strong economic conditions abroad.
Amid a massive decline in spot prices for virtually all commodities worldwide, the Baltic dry freight rates have really tanked, from a high of 12,500 in May to 775 on Dec. 31. This massive drop in rates is particularly disturbing given all of the stimulus efforts the Chinese government has attempted.
No wonder the price of crude oil went from $150 to $40 in less than six months, and no wonder commodity producers such as Freeport-McMoRan (FCX), BHP (BHP) and Potash (POT) are all down substantially from their mid-summer highs.
Since credit spreads are generally a leading indicator to equity prices, it is worth noting that the substantial narrowing in spreads suggests that equity prices could see a pop in coming weeks. However, a substantial move higher is unlikely given the massive decline in overseas growth.
Posted on Jan. 5, 2009
