Global financial markets show signs of renewed stress

The difference between the three-month forward London Inter-Bank Overnight Rate (LIBOR) and US overnight index swaps (OIS), a critical indicator of global financial conditions, is currently approaching the danger zone. This level of stress was last seen after the first round of sanctions imposed by Western economies on Russia in March 2022, following the Russian invasion of Ukraine.

Really? Tell me more.

The LIBOR and OIS spread has now risen to close to 40 basis points, a level last seen in March 2022, following Russia’s invasion of Ukraine.

The indicator spiked on September 28 amid the mayhem caused by the surge in the US dollar against global currencies, and the emergency intervention by the Bank of England to stem an evolving financial stability issue in the country’s money market after government bond yields soared to levels last seen during the Great Financial Crisis of 2008.

Why should I know this?

A rising LIBOR-OIS spread indicates the banks are demanding higher interest rates from each other to protect against potential defaults in the future or that demand for funds from lenders is so high that it is outpacing supply, indicating the potential for future stress.

It’s a pretty good barometer to gauge if banks are finding it hard to borrow money in the inter-bank market for funds. Finance professionals always look at this indicator to tell if a disaster is about to strike global financial markets.

Although the spread is still not near the 80-bps mark hit during the depths of the COVID crisis in March 2020 or the 170-bps level hit in November 2008 in the aftermath of the collapse of Lehman Brothers, the timing of the spike is important.

Why so?

The surge in the LIBOR-OIS spread, as it is often called on Wall Street, comes at a time when the US Federal Reserve’s balance sheet is still the biggest in its history, at more than $8 trillion, and when it is receiving in excess of $2 trillion in cash from lenders in its repo window.

The rise in the spread at a time when US dollars are hard to find and some market participants are finding it difficult to refinance their current short-term debt obligations is a sign that investors are fearful of what Allianz Chief Economist Mohammed Al-Arian termed “financial accidents” going ahead.

Hold on. What’s LIBOR and OIS?

LIBOR is one of the benchmarks most widely referred to by financial institutions across the world to price loan products from credit cards to large corporate loans. In India, the equivalent of LIBOR is the MIBOR or Mumbai inter-bank overnight rate.

The three-month LIBOR is the most widely used benchmark by lenders to decide how much to charge borrowers for short-term loans.

Also read: The seven economic wonders of a worried world

An overnight index swap is an instrument that is used by financial institutions to hedge against the risk of interest rates on their short-term borrowings rising or falling due to market conditions. The OIS is pegged to the policy rate of the economy, which, in this case, is the US Federal Funds rate.

Okay! So what now?

The reason the LIBOR-OIS spread has gained significance is because the US Federal Reserve, inarguably the central bank of the world, tracks this indicator to decide if it needs to take action in the market.

Days after the spread started ringing alarm bells in the US money market back in March 2020, the US Federal Reserve announced infinite quantitative easing — the promise to buy bonds and mortgage-backed securities from the market for as long as necessary and at whatever cost.

The Fed’s move back then helped the US and the global economy avoid a financial crisis similar to the Global Financial Crisis.

Do I need to be worried?

Not yet.

While the LIBOR-OIS spread has spiked, it is still not a sign of a broader financial crisis in the global markets. While what is happening in the UK markets will concern investors, there is no similar stress visible in the US or Asian economies.

That said, the widening of the difference between the interest earned from a 10-year Italian government bond and a similar German government bond beyond 200 basis points will worry the European Central Bank.

In the past, the ECB had unleashed bond buying programmes to reduce the spread and reassure the market that weaker European economies would not face a funding crunch due to the rising cost of debt.

Market watchers in the US, at the moment, believe that if the LIBOR-OIS spread continues to move higher and moves beyond the 50-basis-point mark, then the Fed could be forced to step in to prevent any “dysfunction” or “collapse” in market sentiment.

Critically, for stock market investors, a decline in the spread will be an indicator that risk in the financial system is easing, serving as a cue to pour money back into riskier but more rewarding assets such as equities.