Despite the Bernanke's efforts to improve the credit situation, and recent drop in the LIBOR OIS *1 and TED Spread *2 did not make any difference in bank lending. Banks refused to lend to businesses due to uncertainty in the U.S. economy. The recent issuing equities to raise capital by many banks, tells me that even bankers don't believe in this rally. Therefore they took advantage of the bear market rally to raise capital, before indices head lower again.
The only reasonable explanation of drops in LIBOR and TED Spread is Fed quantitative easing and massive Fed intervention in market by pumping unbelievable sums of cash. On the other hand drops in LIBOR could be a sign of improving bank liquidity as customer deposit growth replaces borrowing in the short-term money markets.
In such an economics uncertainty banks keeping huge sums in reserve and refuse to lend therefore excess liquidity have no where safe to go except into the Treasury or Inter-Bank lending. On the other hand Bankers are risk takers by nature,they received big sums of cash through TARP & TALF obviously they should put it to work. They flood the stock market and bond market with free government money that explain the recent rally or as I call it "assets inflation". Fed quantitative easing to buy Treasuries and to cut interest rate to (0% to 0.25%) at the same time; caused Treasury became unattractive to financial institutions. When Treasuries drop near ~0%*3 there is not any benefit to buy them, banks rather hold cash or invest it in stock market, that's why Fed has been buying treasury, but Bernanke has been denied buying treasury bonds.
China is the biggest U.S. debt holder, they don't have any other options beside continuing buying our debt, because if they suddenly stop to buy our debt it will cause the big drop in the U.S. bonds and ultimately they will lose a lot of money. On the other hand they have started to take action and paying attention to diversification in their investments. They invested heavily in commodities and other currencies. Treasury issued huge amount of bonds to pay for bailout and other government spending, China has increased their purchase, but they did not catch up with increasing rate of debt issued by the U.S. treasury. Chinese did not participate in treasury auctions as strong as they used to. Therefore Fed stepped in and starts to print money to buy Treasuries this phenomena known as "debt Monetization" *4.
"Click on the table to zoom in."
On the other hand bankers has to circulate their excess cash. The only safe option left is the Inter-Bank lending. The excess supply in Inter-Bank lending caused recent drops in LIBOR. The decline in LIBOR has more to do with deposits reducing demand for funds in the interbank market to anything else. I need to remind my readers that deposits at U.S. banks jumped by almost $400 billion in the past six months which has been improving the banks liquidity.
The sharp drops in LIBOR is a sign of improving bank liquidity as customer deposit growth replaces borrowing in the short-term money markets, and it is not necessarily a sign of the willingness of banks to lend and improvement in the credit market.
*1 LIBOR (London Inter-Bank Offer Rate): Is the interest rate that the banks charge each other for loans (usually in Eurodollars). This rate is applicable to the short-term international interbank market, and applies to very large loans borrowed for anywhere from one day to five years. This market allows banks with liquidity requirements to borrow quickly from other banks with surpluses, enabling banks to avoid holding excessively large amounts of their asset base as liquid assets. The LIBOR is officially fixed once a day by a small group of large London banks, but the rate changes throughout the day.
*2 TED Spread: Is the difference between the rate for Treasury Bills and the rate for Eurodollar Bills. The resulting price discrepancy is an indicator of credit risk. An increasing TED spread is thought to indicate increasing risk, while a decreasing TED spread is thought to indicate decreasing risk.
*3 Treasury as of May 15th:
Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr
(%): 0.11 0.17 0.29 0.50 0.88 1.30 2.01 2.65 3.14 4.07 4.09
*4 Debt Monetization: Is a two step process where the government(Treasury department) issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of high powered money that causes inflation on the long run.
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