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FOMC preview: Rising stress edition

Summary:
The Federal Reserve is widely expected to raise interest rates a quarter-point this week at their FOMC meeting this week. Even though financial conditions remain at benign levels, there are a number of signs that stress levels are rising during the current tightening cycle.  Rising Libor-OIS spread Bloomberg reported that stresses are showing up in the financial system as part of the Fed’s tightening process. The Libor-OIS spread is blowing out.  As a primer: [The Libor-OIS spread is] regarded as a measure of how expensive or cheap it will be for banks to borrow, as shown by Libor, relative to a risk-free rate, the kind that’s paid by highly rated sovereign borrowers such as the U.S. government. The Libor-OIS spread provides a more complete picture of how the market is

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The Federal Reserve is widely expected to raise interest rates a quarter-point this week at their FOMC meeting this week. Even though financial conditions remain at benign levels, there are a number of signs that stress levels are rising during the current tightening cycle.
 

FOMC preview: Rising stress edition

Rising Libor-OIS spread

Bloomberg reported that stresses are showing up in the financial system as part of the Fed’s tightening process. The Libor-OIS spread is blowing out.
 

FOMC preview: Rising stress edition

As a primer:

[The Libor-OIS spread is] regarded as a measure of how expensive or cheap it will be for banks to borrow, as shown by Libor, relative to a risk-free rate, the kind that’s paid by highly rated sovereign borrowers such as the U.S. government. The Libor-OIS spread provides a more complete picture of how the market is viewing credit conditions because it strips out the effects of underlying interest-rate moves, which are in turn affected by factors such as central bank policy, inflation and growth expectations.

The rising spread can be attributed to a number of factors:

  • Higher Treasury Bill issuance
  • The tax bill’s offshore cash repatriation provisions has shrunk the supply of overseas USD
  • Quantitative Tightening, or the Fed’s shrinking balance sheet

Flattening yield curve

The yield curve has continued their flattening path, which is the bond market’s way of anticipating slowing future economic growth. Inverted yield curves have been sure-fire signs of recessions, which have been equity bull market killers in the past.
 

FOMC preview: Rising stress edition

On the other hand, Matt Boesler of Bloomberg pointed out that even though core PCE has started to rise steadily, its pro-cyclical components remain tame. This may be a factor that holds down inflation pressures for the rest of 2018 and restrain the Fed from becoming overly aggressive in its rate hike path.
 

FOMC preview: Rising stress edition

At this point, the market does not have a good handle of the Powell Fed’s reaction function to data and risks. Ultimately, the question for investors is whether there will be a Powell Put for the markets in the manner of the Yellen Put, Bernanke Put, and Greenspan Put.

Stay tuned. The first act of this show opens on Wednesday.
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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