Distressed Volatility

Looking at what's going on in the inter-bank lending and forex market is really interesting. I never thought it would come down to a global funding freeze. Money flow is like blood flow, blood is needed to transfer important nutrients to cells, money is needed for the transfer of goods and services between businesses and people. Without the availability of short-term credit (1-mo., 3-mo.) by lending institutions, the problem trickles down to every company needing immediate liquidity to fund payrolls and day-to-day expenses. This is happening right now. With the fall of Lehman Brothers and so many others on the brink of nationalization, lending between banks have frozen up due to this insolvency exposure risk. Nobody knows who is infected which is the reason why Libor rates spiked. Also, the inter-bank lending pressure has hurt those in need of U.S Dollars, which could be part of the reason why the value of the U.S Dollar has increased (lack of supply and institutional hoarding). This forced institutions in need of $US to go out into the forex market and bid it up. Since this continued pressure will have a drastic impact on our economy, the Fed is trying to relieve this pressure by funding 3-month commercial paper directly, lowering the fed funds rate and maybe even taking direct stakes in banks. The Libor rate usually is in lockstep with the fed funds rate, but they've diverged significantly which is a big concern. Plus lowering the Fed funds rate won't work if there's no lending going on, it could spark confidence but a recession would just counteract that effect. Once credit is able to flow again to mid-prime borrowers the crisis will be solved. With the Fed performing 3 day's worth of surgery, 1-month and 3-month Libor rates still haven't come down. Banks are just flat out scared to provide capital. But since there is a lag effect to the fix, here is an optimistic view, along with 1-mo and 3-mo Libor 10 day libor charts below. The carry trade unwinding is also an interesting story, stay tuned.

"Source: Banks borrow record $420 billion per day from Fed (Reuters, 10/9/2008)

"The Fed's various measures have not been quick fixes for the CP market, but they will eventually help. "People act on a lag. It's not a night-and-day difference," said Deborah Cunningham, chief investment officer for Federated Investors' taxable money markets, on Wednesday. "But people are gaining confidence and that confidence is what is needed to restore normal operations, and it's coming back slowly.""

1 Month Libor Rates (10 Day Chart) - Source: Tradesignals.com


3 Month Libor Rates (10 Day Chart) - Source: Tradesignals.com