Wherever the Fed goes, credit markets thaw

Credit markets are thawing. The headline items - LIBOR (London Interbank Lending Rates) and commercial paper - have improved substantially. But corporate bond spreads, although improved, are still wide. As such, there is a very strong correlation between Fed's asset purchases and the associated credit market's health. It is unlikely that credit markets could stand on their own without continued Fed support at this time.

LIBOR: Improving but still above trend

From Investment Postcards from Cape Town:

Lower interbank lending rates indicated reduced strains in the financial system, as seen from the three-month dollar, euro and sterling LIBOR rates declining to record lows. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.83% on Friday. LIBOR is therefore trading at 58 basis points above the upper band of the Fed’s target range - a great improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

It should be noted that as of May 6, banks are sitting on $777 billion of excess reserves that are not being lent out, up roughly $775 billion since April 2008: that's massive federal funding of the interbank lending market.

Commercial Paper: Substantial Improvement

The commercial paper market is returning to "normal" across the financial (green) and non-financial (purple) sectors. The chart illustrates the term lending spread on commercial paper (the 90-day money market rate minus the 90-day T-bill). The spreads have dropped sharply, which is good news for firms wanting to roll over their debt.

The Fed is likely very proud of the outcome of its commercial paper funding facility; and in light of the commercial paper market's improved health, the Fed is unwinding its asset holdings. As of May 13, the Fed had $167 billion in commercial paper on balance, down from $350 billion in January. The commercial paper market can stand on its own now, but of course, one must remember the FDIC program - Temporary Liquidity Guarantee Program - that insures senior unsecured debt, including commercial paper.

Corporate spreads are coming in, but still wide

The chart illustrates the Barclay's corporate spread index of both investment grade credit and below investment grade credit (high yield). I like this index better than the Fed's corporate measures - the Moody's Baa and Aaa indices - for two reasons: (1) Baa and Aaa are both both investment grade indices, and (2) the Barclay's indices span a much broader range of sectors, including financials and utilities - as of 2001, the Moody's Aaa covers just the industrial sector.

The spreads have surely tightened, but remain elevated compared to their longer-term trends (average over entire sample, indicated by the horizontal lines), 601 bps for high yield and 170 bps for investment grade.

The Fed is not accumulating term corporate bonds, so any improvement is purely market driven.

The point of the story is: if the Fed is in the market, then that credit market appears to be functioning well; if the Fed is not in that market, then that market is likely still stressed. Furthermore, the Fed will probably maintain its massive balance sheet until it is certain that credit markets can fully function without its support. That time has not yet come.