Economic Markets Update – The New Normal, Nonetheless Unclear

The readjustment into what will be considered normal operating conditions for the markets continues. Stock markets despite a brief wobble have bounced back and key indices remain at 18 month highs, and Greece aside, developed market government bond markets seem to remain relatively range bound in spite of the imminent need for a deluge of issuance.

There are some interesting ‘phenomenon’ being picked up by some commentators in the financial press, some of which may prove to be nothing more than blips, whereas others may indeed be illustrative of the new normal operating environment.

The seizing of credit markets in 2008 was triggered by the lack of the ability of banks to secure short term financing to provide them with their day to day liquidity. For years preceding the crisis, banks were able to access funding at the 3-month Libor rate, in the UK this rate typically settled at a few basis points either side of 15bps over the base rate.

In the early days of the unfolding of the crisis the 3-month Libor rate spread to wider and wider of the base rate, and at one point reached over 100bps over. The impact on the banks ability to finance themselves in short term markets precipitated the panic that subsequently gripped the markets driving share prices lower and ultimately causing failures. These rates have now returned to normal following the stimulus measures we saw from Global central banks.

An interesting observation being made today is that of swap rates. Swaps are a means of exchanging a fixed rate of borrowing/lending for a floating rate over the life of a transaction. The floating rate is re-set usually quarterly and is based on a rate linked to interbank funding, which, as above has a relationship to the underlying base rate of a country.

Typically government bond yields have trade lower than the swap rate by varying margins. During the 1998 Russia led crisis, the 10-year $ swap rate blew out to over 100bp similar to the Libor example above, however at this time it was as investors scrambled to get out of Emerging Markets and into the ‘safe haven’ of US government bonds driving yields down aggressively.

What seems to be clear is that whereas previously there was expected to be a degree of correlation in Globalised market movements, there is now much more scope for regional and indeed further micro driven anomalies.

In 2010 as developed governments battle with massive debt, the reverse is actually happening. In the US there is a converging of these rates, with the US already at record lows with the US 10 year swap spread now at a record low of 4bp. In the UK this spread is actually now negative.

This is clearly not necessarily indicative of another crisis of the magnitude of 2008, and whilst an interesting phenomenon could purely be due to the new supply dynamics, and simply just ‘new normal’.

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