Swap Spreads
- A sharp widening in two-year swap spreads reflects an increase in expected Libor rates versus short-term government borrowing and is a measure of increased funding stress / deteriorating credit conditions in inter-bank borrowing.
- A sharp widening in five-year swap spreads reflects a flight-to-quality trade when investors seek safer government debt over a proxy for highly rated, non-financial corporate borrowers.
- The EUR Basis swap represents the give-up in the market rate in Euribor versus Libor and represents the scarcity of dollar funding for borrowers in the euro zone. A very large negative spread represents a larger premium for Libor funding over Euribor funding.
- (Swap spreads are a popular way to indicate the credit spreads in a market. It is defined as the spread paid by the fixed-rate payer of an interest rate swap over the on the run treasury with the same maturity as the swap. For example, if the fixed-rate of a 5-year fixed-for-float LIBOR swap is 7.26% and the 5-year Treasury is yielding at 6.43%, the swap spread is 7.26% - 6.43% = 83 bps.)
Eurodollar Futures
- A sharp increase in yields in the first four contracts and a simultaneous rally in the next four represents signs of funding stress, as short-term borrowing rates spike relative to the rest of the funding curve.
- ( Eurodollar futures contract refers to the financial futures contract based upon Eurodollar deposits (which are US dollar-denominated deposits), traded at the CME. They are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future. Each CME Eurodollar futures contract has a notional of "face value" of $1,000,000.
CME Eurodollar futures prices are determined by the market's forecast of the 3-month USD LIBOR interest rate expected to prevail on the settlement date.
A single Eurodollar future is similar to a forward rate agreement to borrow or lend US$1,000,000 for three months starting on the contract settlement date. Buying the contract is equivalent to lending money and selling the contract short is equivalent to borrowing money. (Note that a contract is different from an actual loan due to a lack of convexity as well as the fact that credit risk is only on the margin account balance.) )
- The 3s1s basis is a spread to one-month Libor that investors can lock in in exchange for three-month Libor at a specified forward date. Widening occurs as long-term funding becomes more scarce, reflecting higher liquidity and term premium
- Similarly a widening in the 3s6s basis reflects scarce long-term funding in the money market and reflects higher liquidity and term premium.
- The FRA-OIS spread represents the spread between the uncollateralized Libor borrowing rate in the inter-ban market versus a highly correlated proxy for the expected funds rate over a three-month period at a specified forward date. A widening in spread represents increased funding stress in teh banking system.
- A widening in CDS across major indices represents a deterioration in the credit outlook
EU Debt Spread
- Represents the spread of five-year European sovereign debt to the five-year German benchmark. A sharp widening in these spreads represents a deterioration of the fiscal outlook for these sovereigns.
FX
- A strengthening of the dollar versus euro represents scarcity of overseas dollars potentially driven by funding stress.
3M LIBOR
- Represents the three-month rate that banks are willing to lend in the inter-bank market. A sharp increase in rates is reflective of more demand versus supply of loanable funds in the inter-bank market.
French Banks Equity and CDS
- A decline in the French bank stocks and/or a widening of their CDS may reflect an increase in the likelihood of a sovereign default by Greece given the large exposure of French banks to Greek sovereign debt.
