Credit risk – measured by key money market spreads – has for the first time fallen below levels last seen before the collapse of Lehman Brothers as banks increasingly lend to each other amid growing confidence that the worst of the financial crisis is over.
The gap between London interbank offered rates and overnight market rates – a pure measure of credit risk – on Wednesday dropped below levels on Friday September 12, the last price before the US investment bank collapsed on the following Monday.
This spread is the most important gauge of risk in the money markets because it measures the difference between risk-free overnight market rates and three-month Libor, the key benchmark interest rate banks charge each other for lending.
The narrowing of this spread suggests fears of a financial meltdown – prevalent after the US investment bank went bankrupt – have sharply receded.
Don Smith, economist at interdealer broker Icap, said: “We don’t think the system is about to break down any more, and confidence is certainly coming back. But it is still only a trickle. We are in much better shape than in the aftermath of Lehman as more banks and institutions are willing to lend, but activity is still much lower than last summer.”
However, some analysts cautioned that money markets had been boosted by the powerful rally in equities – and equities may be due a correction.
Willem Sels, head of credit strategy at Dresdner Kleinwort, said: “The equity rally is because the economy and company results are not deteriorating as badly as they were. We need signs of positive growth on both these fronts before we can get too optimistic.”
The so-called overnight index swap spread fell to 68.5 basis points on Wednesday for lending in dollars over three months and 60.5bp for lending in euros.
This measures the spread that three-month Libor trades above a three-month average of overnight market rates. These spreads stood at 86.3bp and 63.4bp respectively on September 12.
The sterling spread is still higher than pre-Lehman, although it has also narrowed sharply in recent weeks. It now stands at 96.7bp. Three-month dollar Libor rates fell to 0.883 per cent on Wednesday, euro Libor dropped to 1.271 per cent and sterling Libor fell to 1.383 per cent.
This compares with October when dollar Libor touched highs of 4.818 per cent, euro Libor hit 5.399 per cent and sterling Libor rose to 6.285 per cent.
Growing convictions that the worst of the global recession is over have also been reflected in other important indicators, such as Vix, known as the Wall Street fear gauge, and credit default swaps.
Vix, which measures volatility on the S&P 500, traded at 33 on Wednesday – its lowest level since September 25, having peaked at 80 in November. Lower volatility is a sign of increasing stability in markets.
The iTraxx Crossover, which measures the risk of bond defaults among high-yield companies in Europe, has also rallied sharply in recent weeks. The index has dropped to 810bp from highs of 1,150bp in early March.