Thursday, October 23, 2008

'Have to Admit It's Getting Better'; Oil Drops Below $67

There have been numerous articles written about the issues with the credit markets recently. Most point to the fact that until the credit markets start to move forward, the global economy and equity markets will be strained. Even though the first checks from the U.S. Treasury to the banks have not been sent, there has been some movement in the last few days on credit. This is the first of many moves that will help the economy and equity markets start to gain traction. Thus, on Wednesday morning, Barron's had a good article written by Randall Forsyth regarding the credit markets and how they have been reacting over the last few days.

Have to Admit It's Getting Better

The Beatles might have been singing about today's money market. What's the next line?

WHEN LIBOR IS THE LEAD STORY in The New York Times and drive-time all-news radio, it's a pretty sure bet that the worst of the short-term credit crunch has passed.

Tuesday, the Times led its page one with news of Monday's dip in the key money-market benchmark rate. Meanwhile, the radio business report was devoted to the further decline in Libor that morning.

Of course, all this was anticipated by readers of Barron's. It reported last weekend a strong rally in futures contracts tied to Libor Friday, which portended the sharp declines in the key rate Monday and Tuesday ("A Thaw in the Freeze," Oct. 20.)

The three-month London interbank offered rate fell to 3.83375% Tuesday, nearly 100 basis points (one percentage point) below its peak only a few days ago. But Libor still is 100 basis points higher than where it stood in September before the current crisis erupted with full force.

That's of more than academic interest to the companies with the billions of business loans tied to Libor or American homeowners whose adjustable-rate mortgages' interest rates are dependent on an interest rate set across the Atlantic.

More than the absolute drop in Libor, the key rate also fell relative to other benchmarks, such as Treasury bills and the Federal Reserve's overnight federal-funds rate target. That indicates an easing of fears in the money markets, analogous to a fall in the VIX for the stock market.

According to Morgan Stanley money-market maven George Goncalves, the TED spread -- the difference between Libor and T-bills -- by Tuesday had shrunk by 89 basis points, to 275 basis points, since Friday.

Compared to the overnight interbank swap rate -- which measures where the market expects the moving target for fed funds to be in the months immediately ahead -- the Libor-OIS spread has contracted 53 basis points, to 277 basis points, since Friday.

Despite these marked contractions, the TED and OIS-Libor spreads still are extremely wide relative to their historic norms. Which means that the crisis isn't over by any means.

By the time you read this, banks in London will have fixed Libor for Wednesday, no doubt sharply lower again.

And, according to the futures market's reckoning, Libor should average 2.60% in November, which would still be a relatively wide spread from OIS. By early 2009, three-month Libor should bottom around 2.15%, while the fed-funds rate should trough between 1% and 1.25%, according to the futures market, leaving a spread of more than 100 basis points.

Helping to relieve pressures on the money market further was the announcement of the MMIFF, the Money Market Investor Funding Facility. That's the latest in the alphabet soup of Fed programs, this time to provide up to $540 billion to provide liquidity to money-market mutual funds. Money funds can sell instruments such as commercial paper they can't unload on the market to a special purpose vehicle financed by commercial paper funded by the Fed. Got that?

Elsewhere, yesterday's TAF auction was undersubscribed. Translation: banks didn't bid for all the Term Auction Facility money the Fed offered, and paid only 1.11% for what they did borrow. That means they weren't strapped for dough. And that's a good thing.

(At this point, Fed financing facilities could make a category on Jeopardy: "Alex, what is PDCF?")

Elsewhere on the credit beat, another disaster didn't happen in the settlement of Lehman Brothers' CDS. That stands for credit default swaps, insurance policies against the bankrupt investment bank going bust. Which, of course, did happen. Tuesday was the final day to settle up the claims, which conjured fears of somebody having bet wrong not being able to pay up.

It went off without a hitch, as it turns out. Perhaps $6 billion of cash changed hands on $400 billion worth of Lehman CDS outstanding. How's that possible? Say a big investment bank might have sold $11 billion of Lehman CDS but also bought $10 billion. There was $21 billion of Lehman CDS outstanding, but the firm had only a net $1 billion of exposure.

This was like a property-casualty insurer having written homeowner policies with a hurricane approaching. Most of the exposure was reinsured. And for the rest, the insurer had to post more collateral as the barometer dropped. That's how the CDS market works.

As a result, the Lehman CDS settlement was a non-event. But, if ever there was a time that no news is good news, this is it. The mysterious nature of credit default swaps raised the specter that insurers that had written policies could default, leaving billions of unpaid claims. That didn't happen, and the market's worst fears weren't realized.

Back in 1967, the Beatles sang on Sgt. Pepper's Lonely Hearts Club Band, "I have to admit it's getting better…" "Can't get no worse," was the lyrical response.

Not much has changed in four-plus decades.

Oil Drops Below $67

Oil prices tumbled below $67 a barrel to 16-month lows Wednesday after the government reported big increases in U.S. fuel supplies -- more evidence that the economic downturn is drying up energy demand.

The Energy Information Administration (EIA) said crude inventories jumped by 3.2 million barrels last week, above the 2.9 million barrel increase expected by analysts surveyed by energy research firm Platts. Gasoline inventories rose by 2.7 million barrels last week, and inventories of distillates, which include heating oil and diesel, rose by 2.2 million barrels.

Over the last four weeks, the EIA said, motor gasoline demand was down 4.3% from the same period last year. Distillate fuel demand was down 5.8%, and jet fuel demand was down 9.2%.

"The main theme here that's driving this market into new low ground is demand deterioration," said Jim Ritterbusch, president of energy consultancy Ritterbusch and Associates. "As we begin to see evidence that demand is leveling -- it doesn't have to increase, just level -- then we can start discussing a possible price bottom. But it appears premature at this point."

Light, sweet crude for December delivery fell $5.43 to settle at $66.75 on the New York Mercantile Exchange, after falling as low as $66.20. It was the lowest close for a front-month contract since June 13, 2007, when crude settled at $66.26.

The dollar's strength this week relative to other currencies has contributed to oil's decline. Investors often buy commodities like crude oil to hedge against a weakening dollar, and sell those investments when the dollar rebounds.

The euro fell below $1.28 for the first time in nearly two years Wednesday. The 15-nation euro dipped as low as $1.2736 in morning trading before recovering to $1.29, still down from $1.3003 late Tuesday in New York.

Meanwhile, the Organization of Petroleum Exporting Countries (OPEC), which accounts for about 40% of global oil supply, signaled that the group plans to announce an output quota reduction at an emergency meeting Friday in Vienna.

Russia's top energy official said Wednesday that Russia, the largest oil producer outside of OPEC, may set aside an oil reserve to influence global prices -- but won't cut output, according to news reports. Deputy Prime Minister Igor Sechin said the government was considering creating an oil production reserve "which would allow it to work more efficiently with prices on the market."

Barron's, Reuters, Marketwatch

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