Money market spreads offer a real-time insight into the amount of risk being priced into interest-rate transactions and can provide real-time metrics of larger financial and economic challenges.
A further spike in money-market spreads as the virus grows worse could imply a deterioration in lender confidence.
The upset in financial markets over the past two days has caused a move in sensitive risk spreads implying potential credit market challenges should the crisis spread into the real economy, a probability we still estimate as quite low.
The greater the perceived risk of default on a loan, the higher the return demanded by the lender relative to a risk-free security. We measure this risk as the difference between the benchmark lending rate – the three-month Libor rate – and the three-month Overnight Interest Swap (OIS) rate, which is based on the federal funds rate for which credit risk is not considered to be a factor.
Before the Lehman collapse
In the run-up to the bursting of the housing bubble and the collapse of Lehman Brothers in September 2008, the stock market collapsed suddenly at the end of June 2007 while the Libor-OIS spread shot up from less than 10 basis points to 100 basis points — both of which were signals of the coming collapse.
By the time it was evident that Lehman Brothers did not have access to liquidity in September 2008 and could not meet its obligations, the Libor-OIS spread had reached 250 basis points. The spread peaked at 350 basis points as the global financial markets froze entirely before being given lifelines of credit from the Fed.
Since then, there have been relatively minor spikes in the Libor-OIS spread during the European debt crisis and, more recently, during the on-again, off-again cycle of U.S.-China trade negotiations and tariff impositions.
Looming threats
If the 2018-19 Libor-OIS spikes were the result of policy uncertainty as China and the U.S. volleyed tariffs back and forth, a further spike in money-market spreads as the coronavirus outbreak spreads could imply a deterioration in lender confidence, which is ultimately a greater threat to sustained economic growth than equity-market speculation.
Unfortunately, the latest financial market news is becoming frighteningly similar to June 2018. The Dow lost 1,900 in two days as of this writing (February 24-25) and the Libor-OIS spread is looking as if it could move higher.
If this spread continues to widen one should anticipate that the Federal Reserve will move to bolster financial conditions. Should the public health emergency spread to the U.S. and result in a broad economic disruption, then the fiscal authority will need to step in to provide liquidity to the small and medium enterprises that make up the real economy.
