If your biggest concern as an investor right now is the trade war, or regulation on the technology sector, or even the threat of a new geopolitical conflict, then you might not be digging deep enough into some of the headwinds the U.S. economy currently faces.
To be sure, the risks I just mentioned are legitimate and should be monitored closely going forward. But they are also what I’d refer to as ‘headline risks’ – widely known, widely discussed risks that are probably already baked into stock prices. In my view, these types of risks generally have less pricing power and are rarely – if ever – strong enough to trigger a bear market.
On the other hand, the risks that almost no one talks about are often the more impactful ones we should pay close attention to. And there is a budding risk today that we believe fits the profile: a widening Libor OIS spread that is signaling tightening financial conditions in the U.S. Never heard of it? My point exactly.
What is the LIBOR-OIS Spread, and Why Does It Matter?
You might be hearing the term ‘LIBOR-OIS spread’ more often going forward, so let me break it apart for you. The LIBOR is the average interest rate that banks charge each other for short-term, unsecured loans. The utility of LIBOR is to give banks around the world a rough idea of how much it costs (interest rate) to borrow money in the short-term. For consumers, the LIBOR is important because it is generally what banks then use as a starting point for determining mortgage rates, student loans, credit cards, etc.
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The Overnight Index Swap (OIS) rate represents a specific country’s central bank rate, which in the case of the U.S. is our fed funds rate as determined by the Federal Reserve. At the end of the day, the spread between the LIBOR and the OIS should give market participants an idea of credit conditions in a particular country. A higher spread means that banks are demanding more interest for dollars lent, which may also mean they see increasing risk in the credit markets. In short, a widening LIBOR-OIS spread means that banks want extra interest to compensate for extra risk.
You probably know what I’m going to say next: the LIBOR-OIS spread has been widening fairly substantially since the beginning of the year.
Banks have been steadily charging each other more for short-term money, and as a result the LIBOR has been creeping up to levels we saw in the years leading up to the financial crisis in 2008. We’re not at ‘sound the alarm’ levels yet. But the steady ascent has been noteworthy and rather quick in calendar year 2018. In short, financial conditions are tightening here in the U.S., and very few people are talking about it.
3-Month LIBOR Rate (Note the Sharp Uptick in 2018)
Source: Federal Reserve Bank of St. Louis; ICE Benchmark Administration Limited (IBA)1
Bottom Line for Investors
The 2008 financial crisis was an extreme case where tightening financial conditions brought the economy to a screeching halt. In our view, we are nowhere near those conditions today.
But, we believe that investors should be on notice that a rising LIBOR-OIS spread – coupled with the Federal Reserve shrinking its balance sheet while raising interest rates – are the types of factors that can quietly slow down an economic expansion and slow the flow of money into risk assets. And, in our opinion, those two effects together can serve as a type of gravity on stock prices.
In the near term, say the next 3-6 months, I think the momentum of corporate earnings growth and the impact of fiscal stimulus will keep this risk at bay. But we will be watching it develop closely, and I’d encourage investors to do the same.
To help you do this, I invite you to download our Just-Released May 2018 Stock Market Outlook Report2 >>
Disclosure
[2] Zacks Investment Management reserves the right to amend the terms or rescind the free Stock Market Outlook Report at any time and for any reason at its discretion.
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