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Stock Markets Fall, Japanese Yen Rallies, and Treasury-LIBOR Spreads Widen

Friday, 10 October 2008 13:17:03 GMT  |  Antonio Sousa, Chief Strategist and David Rodriguez, Quantitative Analyst

The credit crisis that began in the United States is now affecting the global financial system in full force and stock markets around the world have been selling off on speculation that the world economy could fall into a deep recession.

The LIBOR, a rate that banks use to charge each other for loans, rose to 4.82 percent and there is a growing concern among international investors that any government plan will fail to stabilize the credit markets. The Japanese yen has been the main beneficiary of this lack of confidence in the financial system and the current environment of uncertainty and de-leveraging in financial markets makes high yielding currencies vulnerable to a complete collapse.

The key Treasury-Eurodollar (TED) spread continues to deteriorate, as yields on 3-Month Treasury Bills have fallen 16 basis points overnight and the LIBOR has gained 7bp. Such rapid deterioration is hardly a sign of confidence in the financial system; the widened yield differential makes it clear that investors greatly prefer the safety of government debt despite exceedingly-low interest rates.

The doom and gloom in broader financial markets has likewise begun to affect forex traders, as major banks pull their price feeds from major currency pairs. If major banks are unwilling and/or unable to provide liquidity and prices in the heavily-traded EURUSD, it signals that there is a truly pronounced shortage of liquidity and lack of confidence in financial markets. Indeed, the vast majority of over-the-counter foreign exchange trades settle within a mere 5 hours—making counterparty risk negligible.

The chart below shows Bid/Ask spreads available in FXCM retail trading accounts from year-to-date. Since FXCM uses prices provided directly by the world’s major institutions’ currency dealing desks, this is an accurate picture of spreads available in interbank markets. FXCM markups are accounted for in the below spreads.

Progressively worse forex market conditions clearly signal that financial markets remain at a high level of stress. Such episodes of market panic typically translate into a flight to safety across all traded financial markets, and the primary recipient of such funds in the currency world is the Japanese Yen. We see the Japanese Yen continue to soar against all major currency counterparts. Indeed, the table below shows exactly how much the Yen has rallied since yesterday’s New York close. Continued distress in financial markets could only lead to further Yen strength.  

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