Spreads, Credit Fears and Principal Conservation

The following chart tracks the yield of 3-month US Treasury bills; recessions are marked in gray (click to enlarge). With the exception of 1984-86 when inflation came down rapidly due to plunging oil prices, every time T-bill yields dropped significantly the US economy entered a recession, or was already in one. The reason is that investors facing recessions get out of riskier assets such as stocks and corporate bonds and park their cash in T-bills, instead.

Three Month T-Bill Yield Chart:FRB St. Louis

The same thing is happening today, but with an important twist. The current credit crisis is targeting specifically the short end of the yield curve. The failure of the SIV - ABCP and other structured finance markets has increased demand for the safest possible short-term instruments, i.e. T-bills. While 3-month bills are now at 2.85%, bank certificates of deposit (CDs) with the same maturity are at 5.00%, 3-month LIBOR (the rate at which banks lend to one another) at 4.86% and commercial paper issued by financial institutions at 4.90%.

The spread between T-bills and such rates is the main credit fear indicator for money markets. The next chart shows the spread between 3-month bank CDs and T-bills (click to enlarge). It is at 2.15%, the highest in over 20 years.

Data: FRB St. Louis

However, even this big spread understates the magnitude of the current crisis because it is in absolute terms, not relative to current interest rates. It is one thing for spreads to be at 2.15% when market rates are at 10% and very much another when they are at 3%. For proper perspective, the next chart tracks the spread as a percentage of T-bill rates (click to enlarge).

Data: FRB St. Louis

The ratio is now at the highest point in at least 43 years (75%), meaning that investors are so concerned about getting their money back after three months that they are willing to forgo a record 75% more income available through CDs than from T-Bills (2.15%/2.85%). This is not mere credit fear, but full-out principal conservation mode.

Effectively, the money market has ceased functioning normally. Banks rely instead on borrowing unprecedented amounts from central banks and this explains the ECB's decision last week to provide "unlimited" liquidity and the Fed's announcement that it will continue its TAF operations for as long as it takes. The central banks have drawn a line in the sand, betting that they can ultimately win the battle against fear.

This is a very fragile state of affairs. Despite the rhetoric, even central banks do not posses enough resources to fund the entire system and one more wave of major credit-related news could easily wipe out the line.