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Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets


Connecting the dots between the decline in the need to hedge to a decline in the demand for credit, and looking at early harbingers of the oil and scrap industries.

Friday there were two headlines that caught my eye regarding two events that had not happened in the last 20 years: the US 2YR swap spread hit 10.5bps, and the Chinese yuan traded through 6.28 per dollar. At first glance you would not assume the two are related, but I believe they could both be indicative of an important underlying trend.

Swap spreads have been falling since the Fed's commitment to keep a lid on short term interest rates and the general presumption is that it is due to the lack of demand for hedging rising interest rates. A Bloomberg story citing UBS strategists who were recommending 2YR wideners stated, spread tightened.. amid decline in short-term funding needs, "diminished tail risk"; stop-outs in spread widening trades exacerbated 2-yr tightening.

It's the decline in funding needs that I view as the most important reason for the fall in swap spreads. Another short-term interest rate that has been falling is the floating-rate loan benchmark 90 day LIBOR which on Friday hit 33bps, the lowest level relative to Fed Funds for the year at 8bps. Due to the volatility during the financial crisis, many assume the LIBOR spread is a function of risk in the banking system but really it is indicative of the demand for credit. When the demand for credit is strong LIBOR widens and when the demand for credit is weak LIBOR narrows.

In the 90 day LIBOR futures market, which is the eurodollar pit at the CME, the commitment of traders shows commercial hedgers (which are large money center banks) have gone from net long $1 trillion notional at the end of last year to currently being net short $1 trillion. From a historical perspective that is a huge swing. When you are long a Eurodollar contract you are hedging against falling rates and when short you are hedging against rising rates. Therefore the net position of commercial hedgers is indicative of the composition of the banking system's aggregate balance sheet.

Banks hedge assets from falling interest rates and liabilities from rising rates. The fact that hedgers have seen such a big swing in their net indicates there has been a collapse in the need to hedge credit assets on their balance sheets.

The 2YR swap spread and net position of commercial hedgers in eurodollar futures are highly correlated, both peaking in December 2011, bouncing together into the spring of this year and now making new lows in September. You could argue they are saying the same thing. There is no need to hedge against rising short term interest rates with the Fed committed to holding the Fed Funds rate down until 2015 however that doesn't explain why the LIBOR spread is also falling to near zero. When pitted against that the decline in the need to hedge looks more like a decline in the demand for credit.

This decline in credit may have been confirmed by the Fed on Friday in its H.8 release which showed September C&I loan growth of 1.3% to be the lowest monthly annualized rate since the rate was negative coming out of the recession. The previous three months saw growth of 8.8%, 14.6%, and 17.7% respectively so the 1.3% growth rate looks like a steep drop in lending confirming what falling LIBOR swap spreads and Eurodollar positions are indicating.
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