Deconstructing Libor

Henri, in my comments yesterday, has a smart way of looking at the TED spread. The TED spread between Treasuries and Libor, he says, is the sum of two other spreads: the Treasuries-OIS spread plus the OIS-Libor spread. OIS stands for "overnight index swap", and it gives a good indication of where interest rates are when there isn't any credit risk.

So if you're worried about interbank credit risk, it makes sense to look at the OIS-Libor spread rather than the TED spread; the Treasuries-OIS spread is more of an indication of how extreme the flight-to-liquidity play is. As Henri says of the OIS-Libor spread:

This is the true "banking liquidity" component of the TED spread, and the only scary bit... It is the nux of the crisis.

So, how's that OIS-Libor spread doing?

The three-month Libor OIS spread, viewed as an indirect measure of funds availability in the money market, widened to 87 basis points from 77 basis points yesterday. It was as narrow as 24 basis points on Jan. 24. The spread peaked last year at 106 basis points on Dec. 4.

Clearly this is a volatile indicator, if it managed to go from 106bp to 24bp in the space of seven weeks. But equally clearly it's high and rising, as Libor ticks up yet again.

Accrued Interest has a good post today on the usefulness of Libor as an indicator: one thing worth remembering is that it's largely a European interbank rate, with only two American banks participating in the fixing. And one way of looking at what's going on is that illiquidity in the US money markets is increasingly spreading globally. Which can't be a good thing.