It's clear that Europe's debt problems can now be wrapped up into the term credit crunch. In light of operations by the Federal Reserve, the amount of money available for credit appears to be shrinking, while risk premiums demanded by banks are thickening.
On Monday, the 3-month LIBOR-OIS spread rose to a record of .49%, a gain of nearly 11% in just one trading day. This important measurement shows the universal health of the banking system as determined by the LIBOR rate and the overnight indexed swap. The OIS rate is a generally strong indication of money market interest (investors who want little risk, but also little reward) and their favor or disfavor for particular investments.
We've known for quite some time that money market investors are particularly out when it comes to Europe. Since May, American investors reduced their European exposure in money market funds to only $224 billion, less than three-thirds holdings earlier this year.
Meanwhile, banks in the overnight market are especially weary of other banks. As money market investors pull their funds from Europe, other investors must take their place. So far, institutional investors remain too fearful to place funds in another bank - even just for overnight storage. To show the true problems in the market, investors should note the difference between LIBOR and OIS rates in May of .16%. At the start of this week, that spread grew to rest at .48%, an indication that investors are adding in one of the biggest risk premiums seen in quite some time.
Shrinking Fed Balance Sheet
For what it's worth, it does appear that American firms are willing to take bets in Europe. The Federal Reserve reported a monetary base figure of less than $2.6 trillion last month, the lowest reading since June. Yes, for now it does appear that funds on tap at the Federal Reserve are being moved to tackle liquidity issues in Europe independent of major Fed operations.
It remains to be seen whether a drop in the monetary base from $2.7 trillion to just under $2.5 trillion will warrant a future round of quantitative easing. Assuming the Fed holds up with its promises to Europe, the central bank could easily inflate the US dollar by export, allowing for far more liquidity than might be politically possible in the United States.
However, direct injection overseas is hardly beneficial in the United States as far as promoting domestic growth and investment. Quantitative easing, no matter how successful, is always the most successful when deployed within domestic borders. Americans see little benefit from dollars dumped overseas.
Silver could remain weak with LIBOR-OIS spreads above their historical averages of .09-.11% per year for the 3-month spread. Given the massive size of the banking system in Europe - banks make up even more of a proportion of total output in Europe than in the United States - any banking sector weakness will necessarily correspond with general economic weakness in Europe. For 2012, Europe's growth hope is merely an empty conquest; for now, investors should concern themselves with the preservation of investment capital over capital appreciation.