The robust steps taken by the Federal Reserve over the past two weeks to shore up the front end of the money markets are essential to the free flow of capital and global economic stability.
We now anticipate that the Federal Reserve will cut the policy rate by 100 basis points to an effective rate of zero at its March 17-18 meeting. In addition, we do not expect over the next few weeks that the Fed will bring back some of its financial crisis-era liquidity and lending facilities to address the rapidly escalating crisis.
We now anticipate that the Federal Reserve will cut the policy rate by 100 basis points.
Regardless of whether the policy step is cutting overnight rates, increasing reserves to maintain liquidity or restarting financial crisis-era liquidity and lending facilities, the bottom line is that well-functioning money markets are necessary for commercial activity.
The following are a series of accessible metrics that can be used to estimate stress across money markets and help determine when the crisis is intensifying or easing.
Signs of increasing risk
The money markets began to signal distress in the financial sector late in December and into January as threat of the coronavirus outbreak became apparent. When the global equity markets collapsed in the last weeks of February and then again in March, those signals became significantly more worrisome.
The Libor-OIS spread is the interest rate difference required by lenders for funding unsecured three-month agreements (the Libor rate) versus the overnight indexed swap rate, a risk-free rate based on the federal funds rate. The Libor-OIS spread reflects underlying stress in the plumbing of the domestic global financial system. The wider the spread, the greater the stress in financial markets and the likelier that the central bank will need to provide greater liquidity to calm markets.
Expectations for the Libor-OIS spread — known as the FRA-OIS spread — quadrupled to more than 50 basis points from less than 12 basis points when it became apparent that the Fed would need to cut the overnight rate in response to the crisis.
The FRA-OIS spread is widely used as a metric of potential stress in banking. Both imply that right now the public health crisis has caused a financial shock of such magnitude that we are beginning to observe strains that occurred during the financial crisis over a decade ago.
Signs of an increase in volatility
The first half of 2018 was a period of stability in the money markets. Volatility was low and commerce was generally solid as the Fed continued its program of interest-rate normalization, raising the federal funds rate four times.
That lasted until mid-2019, when the trade war triggered a global manufacturing recession that caused significant disruptions along the global supply chain. At that point, with stress building in money markets as illustrated by the 10-year, three-month swaption spread, the Fed began to cut rates.
That volatility subsided again into January, when the coronavirus spread out of China and along the global supply chain. When the world’s equity markets collapsed at the end of February, volatility surged, implying that a greater policy shift by the central bank to maintain stability is likely.
Impact on longer-term securities
There are signs that widening money-market spreads are affecting securities out along the yield curve. The yield on two-year Treasury bonds are considered to be determined by the present value of anticipated money-market interest rates that are a function of federal funds overnight rates. So as the figure below indicates, the two-year swap spread widened in tandem with the three-month FRA-OIS spread. That increase was halted in recent days in anticipation of an upcoming auction settlement and because of demand for longer-term securities in anticipation of more Fed rate cuts.
The impact of the health crisis on global growth and on the demand for safe-haven securities (such as U.S. Treasury bonds) is seen in the difference in the interest rates demanded by holders of investment-grade (high-quality) corporate bonds and Treasury bonds, and the difference between high-yield (more risky) corporate bonds (formerly known as junk bonds) and Treasuries.
When the credit risk of a corporation increases because of lower demand for its product because of an economic slowdown or calamity such as the coronavirus and subsequent stock-market collapse, the spread between a corporate security and a risk-free Treasury bond would be expected to increase. As the figure below illustrates, corporate spreads have widened during episodes of uncertainty that have occurred throughout the past two-plus years.
Signals from the currency markets
Because U.S. securities are the gold standard for investors, offering a nearly risk-free and guaranteed return, you would expect an increase in the demand for dollars by foreign investors. As the figure below shows, this increase in demand is showing up in the premium that holders of Japanese yen are willing to pay in order to hold dollars. This has been evident during episodes of stress caused by the trade war and now the global health crisis, which threatens global commerce and the lives of people throughout the world.
Federal Reserve plumbing
The New York Fed recently announced steps to increase liquidity so as not to disrupt the flow of commerce. In addition, it has taken steps to avoid plumbing issues during end-of-quarter episodes when corporations need funds for balance-sheet purposes by borrowing in the so-called repo markets, as shown in the figure below.
