Rising Credit Stress Could Signal Big Problems for Financials

From Mike Larson: The credit markets are showing signs of growing stress, which could seen spell trouble for the financials.

Earlier this month, I urged you not to ignore some crucial under-the-radarnews on the banking sector. The news: Lenders are increasingly cracking down on pie-in-the-sky commercial real estate lending. They also just started to do so with auto loans … for the first time since the auto bubble began to inflate six years ago.

Now, I’m here with a SECOND major warning — a warning about hidden signs of surging credit stress. In fact, I haven’t seen these kinds of dangerous credit market moves since the weeks and months leading up to the great credit crisis.

Some background first: You know I follow the “Golden Ratio” closely. That’s the spread between higher-risk corporate bond yields and underlying Treasury yields.

But it’s far from the only measure of rising credit risk and/or rising funding costs for corporate borrowers. Below, you’ll find three charts.

The first chart shows the 3-month LIBOR. The abbreviation stands for the “London Interbank Offered Rate,” and it’s a key benchmark of the cost of short-term borrowing for banks and corporations.

The second chart shows the “TED Spread,” or the difference between LIBOR and the yield on credit-risk-free three-month Treasury bills.

The third chart shows the “LIBOR-OIS” spread, the difference between LIBOR and the overnight indexed swap rate. This one is a bit more complex. But you can think of the OIS rate as a benchmark for tracking how much banks are charging on very short-term lending to each other.

Chart #1: 3-Month LIBOR

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Chart #2: 3-Month TED Spread

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Chart #3: LIBOR-OIS Spread

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You can see from the first chart that LIBOR has been rising quite a bit lately. It’s now the highest since the tail end of the credit crisis in 2009. You would expect to see LIBOR rise when the Federal Reserve is hiking interest rates, or talking about doing so.

But you wouldn’t expect LIBOR to rise faster than yields on 3-month T-bills … unless increasing credit stresses were building behind the scenes. Sure enough, T-bill yields have only climbed around 30 basis points since the beginning of October 2015. LIBOR has risen roughly 50 points during that same time frame.

In fact, the TED spread is now at its widest since 2011-2012. That was when the U.S. debt ceiling debacle and European debt crisis were roiling the credit markets. If it widens by just a few points more, it’ll be the greatest spread we’ve seen since the tail end of the great credit crisis.

Finally, I charted the LIBOR-OIS spread over a longer-term time frame for a reason. Go back to the far left of that chart and you’ll see an initial jump higher in this spread in mid-2007. Then you’ll see it climbed steadily until the fall of 2008. That’s when it went vertical as the credit and stock markets “blew up” as Fannie Mae, Freddie Mac, Lehman Brothers, AIG, and other companies either went broke or required massive bailouts.

We saw an initial jump in this spread in late-2015, and it has done nothing but rise since then. It’s getting closer and closer to taking out the late-2011/early-2012 peak, and that bears very close watching. That’s especially true when you consider that other “something is wrong” indicators — like the value of the Japanese yen against the U.S. dollar — are climbing in lock step with these credit risk spreads.

Now I should point out that some on Wall Street are offering up a counter-argument. They’re pointing to new money market fund regulations as the driver of this move. Essentially, the regulations are causing some investment funds to buy less short-term corporate debt and more short-term government paper.

If that were the case, then …

Why would the move be so long-lasting and persistent …

Why would there be a corresponding sharp move higher in the Japanese yen

Why are they coming at the same time as multi-billionaires and noted market experts arepreparing for major market turmoil

And why would the moves “fit” so well with other indicators of rising credit stress, and my thesis of deflating “Everything Bubbles”

The fact is I also recall vividly the same kind of excuse-making and happy talk coming from Wall Street back in 2007-2008 when spreads like these began to widen. They said stock investors should ignore them. But if they did, they got crushed in the ensuing market chaos.

I’m not going to sit here and tell you I have all the answers — no one does. What I am saying is that these indicators have flagged looming trouble in the past — and they’re getting more and more disturbing in the present. So be on alert!

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The Financial Select Sector SPDR Fund (NYSE:XLF) was unchanged at $24.02 per share in premarket trading Friday. The largest U.S. financial equities-focused ETF has risen about 1% year-to-date, trailing the S&P 500’s 7% gain in the same period.

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