I asked Professor David Romer this question this past Thursday: Does the FOMC have a (secret third mandate) of watching financial rates? By this, on a simple viewpoint, means does global liquidity rates affect both FOMC rate decisions and plans?
Sure it seems it would, with the bank (all banks) standing ready to provide liquidity at any sign of trouble. We have Helicopter Ben leading our front in the currency devaluation war, they have Super Mario, and other banks with Governors whose nicknames haven’t been endowed onto them yet because they haven’t hit the print button that quickly yet.
So with this intuitive thought, what would be considered the “danger zone” for liquidity and a signal for the Federal Reserve to step in? Here are some of my findings, 我慢使ってお願いします。LIBORS2
Also note there are no currency charts on this one… forgot to download them and somehow the Bloomy is down.
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Here’s the relatively simple USD 3m LIBOR since earlier this year, showing intrabank lending rates, combining both risk and dollar demand factors. FRA-OIS is a raw measure of liquidity demand.
Both seem pretty normal save for the Winter spikes caused by Greece and Italy fears, LTRO, slowdown of ECB purchases and a whole lot of other smoldering things from Europe.
But doesn’t that LIBOR chart seem somewhat odd? All during that time the Fed kept the window at 0.00%-0.25%, introducing novel and twisty programs and other types of liquidity. There hasn’t been a large derivation of the LIBOR (market decided rate) and the target rate (Fed decided rate) since the Lehman collapse.
Yes, you can argue that Operation Twist was targeting longer term yields, but it still represents some sort of easing. Plus, it’s the only big program in that quarter.
And here’s the similar graph, showing spread and the FOMC rate. Note healthy spreads save for Lehman and crisis. The zig lines from 2004 to 2006 is because my data is bad (they should also be smooth, with a spread of no larger than around 50 bps).
But do notice that after the crisis, the board has been watching the LIBOR rates as well, perhaps trying to keep it from going above 50bps (or a quantitative amount much like the SNB – so it’s not doing something new). LIBOR has been pressured flat due to QE and other short term liquidity operations. However, there are two significant blips during July of 2010 and one recently at the end of 2011.
Yes, both have their causes stemming from Europe. The summer of 2010 was the start of the Greek, Portuguese, Irish + contagion and rapid rate cuts. The most recent one was started with the US’s rating cut (makes sense on the yields front) and garnished with even more burning feta.
For old time’s sake, here’s the main graph since the start of the great recession. At the highest point, LIBORs were 167.125bps above the FOMC rate, representing a gap of over 500%!
Surely enough the fed won’t let that kind of gap happen again. That, I can say with some certainty, is the fed’s second worst nightmare, apart from the dollars flowing home from the rest of the world.
So what is the current safe level? Although data is thin, we do have 2 derivations from the normal flatline – not enough to confirm but enough for guidance.
I’ve taken the liberty of zeroing out some of the “normal” derivations, so this chart only shows spreads that go above 10% the baseline FOMC, so basically every spike in LIBORs. Also, the left and right axis have the same scale, thus the matching of tops.
I have SD calculations in the excel file. It seems that whenever the spread reaches above 25 bps, the Fed starts to monitor the markets. Within the period of a month, the decoupling reaches a peak, and then starts to fall afterwards and around the same rate.
Perhaps the Federal Reserve and other banks may be coordinating plans of actions starting at the month peak without directly telling the public, but it’s always after the peak that they come out with some kind of reform. The July 2010 peak was capped by short term swaps from the ECB, BoE, SNB, BoJ, BoC. This current run was capped by additional adherence to ZIRP and the 2014 promise, which more or less nailed it down. Whatever the case is, the Fed seems to be monitoring market lending rates. And surely we can profit from it.
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So how to trade it?
Didn’t download any corresponding FX data to go with it and the bloomy’s down as well. I’d still sell EURUSD and AUDUSD any day, but currently holding back to see how (and how long it takes) the markets digest the rest of the 2014 promise. By promising the low rates, and with IMF heed, the world economy is still slowing down.
These kinds of export economies, especially Australia, New Zealand and Canada will try to keep devaluing against the dollar (and the pegged CNY for AU, NZ). Even though the exchange rate right now is largely driven by continued rate expectations, overall sentiment should take over soon and give good short points against the commodity currencies.
As for the Euro, I wouldn’t touch it. I’d want to trade the Nordics more than that party that has gone on too long. Maybe the Germans will finally achieve dominance over Europe, and we’ll have Operation Barbarossa again over delicious oil and power.
A digression, my apologies – but I’d have no problems selling USDJPY or XXXJPY (NZDJPY currently, but also monitoring AUDJPY). Countless traders have been burnt trying to all a bottom on that pair, and we know the risks are 1. intervention and 2. default. Let’s see what the government/MoF actually does after the rhetoric. USE STOPS IF YOU ARE TRADING YEN. HOPEFULLY SLIPPAGE WONT BE EXTREME IF THEY DO INTERVENE.
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So, wrapping up an interesting finding that the Fed may after all be watching LIBORs and trying to target it to 0.00% like the SNB. Better yet, they are active acting on it with an almost-set interval. I love it when things follow a schedule.
Now back to watching multi-track drifting trains.
To the best of good buys.
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