LIBOR3 Packs A Punch

One relatively popular method of trying to get a handle on where markets are likely to be headed is to investigate what the TED spread is doing.   There are two components that make up the TED spread: the rate on 3 month US treasury bills and the rate on 3 month London Interbank Offer Rate, more commonly known in the world of charts as LIBOR3.  The TED Spread is the difference between the two.

Over the past couple of years, the FED has pretty much pinned short term treasury prices down near zero, so out of the two components that make up the TED, it has been the European factor that is doing most of  the moving. So for the past year or more, my focus has been on the European end alone... the LIBOR3.

The most important concept to understand is that if the rate of interest that Bank A is charging to loan money to Bank B begins to rise, it means that Bank A is perceiving Bank B of being a slightly riskier entity to lend money to than it was yesterday.  I suppose it has something to do with the commonly accepted premise that when Bank A lends out money, it would like to get it back. The bottom line is that when LIBOR3 is rising, liquidity is no longer flowing as freely it was in days prior.  What is most important when investigating such an important gauge of rates as LIBOR, is not its little day-to-day fluctuations, but the larger trend, and most importantly, any change in direction that might be occurring in that trend.

Let there be no doubt, a change in the direction of the trend in LIBOR3 has a direct correlation with the general direction of the equities markets.  The trend itself doesn't necessarily present an overly tight relationship on a day-to-day basis, mainly because once rates begin to move in one direction, they tend to remain fairly loyal to that trend.  Conversely, equities markets flip flop around on a daily basis like that fish you just landed in your boat.  So to demonstrate the reliability of LIBOR3 as a good indicator of what is likely going to happen in the equities markets, we begin by looking at a longer term snapshot in the weekly chart below:

Click here for a full blown version of the live and updated chart

I draw your attention to the candlesticks which represent LIBOR3.  The orange line represents the rate on 3 month US treasuries but it has been toned down so as not to detract from our focus.  By far, the most import aspect to consider when seeing a change in direction of LIBOR3 is to ask "Why did it change direction?".  As can be seen in the chart above, the FED
had already begun to ease rates in early 2007, a time when it seemed the equities markets were healthy and apparently headed higher forever.  In fact, they were approaching their peak.  What did the FED know that we didn't?

Consider this:  In August of 2006, the FED began to ease up on rates at a time when the equities market had already been surging steadily for the previous 5 years.  At the same time, LIBOR3 suddenly flat-lined.  Up until that point, both FED funds rates and LIBOR rates had both been rising steadily in perfect lockstep, as if to clamp down on an overheating economy.  Again, we ask the question: "Why did rates suddenly flatten out at a time when there was no sign in the equities markets that anything was amiss?  Why would a central bank lower rates in an economy that is apparently hot and getting hotter with each passing week? What did they know that we didn't?".  They knew a liquidity crunch was on the horizon, that's what.  I suppose an analogy could be made that the actions (easing) by the FED "telegraphed" the approaching punch.  LIBOR3 was the punch itself.  In any event, from that point forward it seems that the direction of rates has not been something that the FED nor the ECB has had any choice about... it has all been reactionary.  The word "accommodative" comes to mind.  Perhaps a more appropriate word might be "we're up shit creek and the world can no longer afford high rates and we need to stimulate more free money".

So what happens when rates rise in spite of the preference of central banks?  After all, the world can no longer afford high rates!  I think it stands to reason that this time around, any hike in rates is something that is literally being forced upon the central banks.  This would be an entirely different situation than what was occurring back in 2004-07.  The FED and the ECB now want rates to be held down.  They must be held down in order to prevent a full blown deflationary collapse.  And yet... they are rising.  At least LIBOR3 is.  It would seem that the FED is no longer providing it's role as "telegrapher".  The punches from LIBOR3 are landing anyway.  Call it "blindsiding' if you will.  But the cause of the increase in LIBOR3 is pretty straightforward.  The Banks in Europe are literally becoming reluctant to lend even to each other. And this time the reason for that reluctance is abundantly clear.  They are literally becoming increasingly fearful that the counter party bank might even default. Duh!  I'd be asking a little higher rate than 0.55% if I were them.

So we zero in and take a closer look to the more recent action in the daily chart below.  Before you start laughing I should probably explain the goofy little rocket.  I began to present this chart and my arguments that LIBOR was about to begin to rise sharply, as early as August of 2011.  In fact, it was right at the time where the yellow annotation says "The LIBOR fuse has been lit."  As LIBOR began its relentless journey, I added the rocket and the annotation "IT'S LAUNCHED FOLKS, I'M TELLIN' YA".  The rocket was my way of emphasizing that we're not just looking at some minor run-of-the-mill event here.  So quite inadvertently, many people now recognize this as the "rocket chart", so I might as well leave the goofy thing on there for a short time longer.  In any event, rightly or wrongly, I was convinced that we were looking at something far more serious than just a minor blip in rates.  It was all about "Why are they rising?".

Click here for a full blown version of the live and updated chart

As the chart above clearly shows, LIBOR3 began to creep higher in March of 2010 (in spite of the central bankers' preference that it remain low).  Finally, on May 6th, the flash crash event occurred.  At the very same instant, the rate on LIBOR3 surged 16%.  There's no point in arguing the flash crash had nothing to do with lack of liquidity.  It was all about lack of liquidity and the banks knew it.  BAM... that was one solid punch courtesy of LIBOR.  Some will argue that correlation does not necessarily imply causation.  True enough, but you know what?  Who cares?  Whatever it was that caused the LIBOR3 to spike 16% in a heartbeat was also the cause of the flash crash.  The flash crash was no fat finger caused by some punk behind his computer or some bot that went rogue.  Whatever the reason, the flash crash was not even an event caused within the equities markets, it was a reaction to an event within the "liquidity' markets".  The bots only reacted to it and LIBOR3 is simply a way of measuring it. And now, LIBOR is on the rise again.  And as always, just like clockwork, on the day that LIBOR began it's current ride higher, equities reacted almost instantly.  Witness the action of July 22, 2011.

The most important takeaway at the moment is that LIBOR3 has recently surpassed what had been a previous resistance level at 0.054%.  Earlier this month, the inter-bank rate turned lower and appears to be on a mission to retest that level.  I can't see that previous resistance point as doing anything other than providing support now.  To think otherwise would be to assume that for some unknown reason, banks are now somehow healthier than they were just a month ago.  I don't see how that could be possible.  Should that level hold and LIBOR once again bounce and turn higher, then the pressure on equities going forward would likely rise substantially.  I don't see how it would be possible for equities to continue to surge in the face of ever-decreasing liquidity.  They couldn't do it in the past and who in their right mind would expect that they can do it today? 

In any event, a funny thing happened on Nov. 26th.  The equities market suddenly began to defy the fact that rates were still rising.  You can see that event identified by the WTF? comment, which of course is simply asking the question "Why's This Flying?".  Great question!  So is the other one.