Photo: Jon Sullivan. Source: Public Domain Images
The Fed is in Jackson Hole this week, discussing how to design a monetary policy framework that enhances the global economy. Luminaries from all over the world will be there—from other global central bank leaders to politicians to academics. On Friday, Janet Yellen will speak, and she is expected to offer some hints as to how she—and by extension, the rest of the Fed—sees the economy, and where Fed policy might go next.
But what if new regulations have already done the Fed’s job?
The spread between 3-month T-Bills and 3-month LIBOR–known as the TED spread–has been a good indicator of financial stress. When banks are reluctant to lend money to one another, the spread widens. During the run-up to the financial crisis, the spread climbed from 0.20% in 2006 to 1.50% in 2007 and topped out at 3.0% in September of 2008, just after Lehman went bust. The higher the TED spread, the more borrowing costs.
But that was then, this is now. For the past several years, the index has been on auto-pilot. There haven’t been many real threats to the banking system. Concerns about loans in the oil-patch didn’t show up in the TED spread. But lately the spread has moved a lot higher. Why?
TED spread. Source: Bloomberg
Mostly, this has to do with reforms to the money market that are part of the Dodd-Frank legislation. In order to prevent a repeat of the financial crisis, when a big money market fund “broke the buck” and caused a modern-day bank run, Congress decided that all credit-sensitive money market funds have to be flexible in how they price themselves. They can no longer guarantee a stable market price. So as much as $1 trillion held in money market funds is moving into government funds. As a result, banks and other creditors have to pay up for short-term money. Since regulation has permanently changed the money-market landscape, these spreads may be permanently higher.
As a result, financial conditions have tightened. Not as tight as they were during financial or Euro crisis, but certainly tighter than they have been. At Jackson Hole the Fed will talk about the right time to take the punch bowl away. But Dodd-Frank’s money market provisions may have already put a lot of water in the punch.
Douglas R. Tengdin, CFA
Chief Investment Officer