A lot of commentary at the moment will talk of disorderly or stressed financial markets leading to abnormal price movements. They’re not wrong but it often gets lost or overlooked exactly what a distressed or disorderly market is doing. You’ll notice the symptoms of a market showing signs of vulnerability and stress in the rallying of safe havens, and subject to the cause of the stress perhaps a rally in supply-constrained commodities and higher levels of volatility. Particularly in severe episodes of market turmoil you may see an almost indiscriminate purchase of implied volatility across assets, as indeed we have seen over recent trading sessions. The latter purchase of implied volatility demonstrates the approach of ‘if you can’t tell what’s going to happen, position for something, anything, to happen’. Either way, all three of these trading outcomes are secondary effects.
All of these things remain symptoms of financial distress, and they can often be volatile enough to contribute to the noise, rather than the signal, behind the markets. Certainly over this most recent period of volatility catalysed by the Russian invasion of Ukraine, lending markets have been a better indicator of financial unease and have preceded huge swings in safehaven assets like the Dollar and Treasuries. Across many developed markets, a closely watched indicator for financial conditions is the interest rate at which banks will provide short term liquidity to each other versus that of the central bank. In the US, the most popular version of this barometer is the difference between three month Libor rates and the effective Fed funds rate.
Under times of particular uncertainty and volatility, banks desire to hold onto additional liquidity and become happy to sit on excess USD reserves. This reduces their willingness to share liquidity across the financial system and therefore provide short term lending to other banks. This raises the rate at which the Libor component of the above quoted spread is traded at. Whilst the spread between the Fed funds rate and Libor remains smaller than that seen during the outbreak of the pandemic, it is sufficient to constrain funding conditions within the US Dollar and trigger a flight to safety. The spread currently stands at around 38 basis points which does show a significant although likely manageable deterioration in sentiment within markets.
Last week’s ECB USD action showed significant demand for Dollars demonstrating the market’s desire to hold USD liquidity. Tomorrow, the Reserve will open its own 7-day swap lines and markets will watch closely the demand for USD via this auction to gauge funding conditions further.
Discussion and Analysis by Charles Porter