Friday, 21 October 2016

Is the next financial crisis going to be a surprise?

As central banks around the world pump billions of dollars into the global economy every month and policy makers pass regulations to safeguard against a relapse of the 2008 financial crisis, the market’s best and brightest say some warning signals are flashing at precisely the wrong time. Now, rules to shore up the money-market fund industry that kicked in Friday are stifling the predictive powers of yet another set of gauges. For investors, the big worry is they will end up being taken by surprise when the next crisis hits.

Libor, the rate banks charge each other for dollar loans ranging from one day to one year, has surged to levels not seen since the financial crisis, even as the Fed has left interest rates unchanged this year. Rather than signalling a credit stress event as it once might have, the spike is the result of structural changes.

The new money-market rules have driven about $1 trillion from funds that buy the short-term debt of banks and corporations into those that invest in safer securities such as U.S. Treasury bills. As a result, banks’ unsecured lending rates have soared. Three-month Libor reached 0.88% Wednesday after touching the highest since 2009 last week. The contortions are also seen in Libor’s spread with other rates. The difference between Libor and the overnight index swap rate, another measure of bank funding stress that isolates credit risk, is at the widest since 2012.

Just last month, analysts at Goldman Sachs Group Inc. reminded investors how the so-called TED spread [which tracks the difference between Libor and the yield on similar-maturity Treasury bills] has lost its ability to foreshadow funding stress. They removed it from the bank’s proprietary financial conditions index.

Analysts are losing faith in the U.S. yield curve, a tool used to forecast the direction of the economy, as it signals a recession that many see as premature. The curve is created by tracing a line through yields on bonds of different maturities. Normally, longer-maturity debt has higher yields than short-dated securities. When that inverts, it is seen as a sign the economy is at risk of contracting. In fact, it has happened before each of the past seven recessions.

While the curve has yet to invert, it has flattened significantly. Strategists say the shift is the product of disentanglement between financial markets and macro-economics. The gap between yields on two- and 30-year Treasuries touched 1.4 percentage points on Aug. 30, the lowest since 2008.

In an even more esoteric corner of the market, a proxy for credit risk called the swap spread has been turned on its head not once but twice in recent months. The gap between the rate on interest-rate swaps and similar-maturity Treasury yields, another measure of bank credit quality, has been negative for most maturities for much of the past year as regulations made it cheaper and safer to use derivatives to hedge risk and more onerous and expensive for bond dealers to trade, hold and finance government debt on their balance sheets.

If that wasn’t enough, near-term swap spreads have swung back above zero this year -- not because conditions are normalizing, but rather due to money-market rule changes that are increasing banks’ borrowing costs in an already distorted market.

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