Greenspan: watch the interest-rate spread

June 24th (moneynews.com) Former Federal Reserve Chairman Alan Greenspan says financial markets will return to normal when an arcane interest-rate spread narrows back to its level prior to the credit crisis.

The spread Greenspan focuses on is the one between the three-month London Interbank Offered Rate (LIBOR) and the overnight index swap rate (OIS).

LIBOR is the rate at which international banks lend dollars to each other.

The OIS measures traders’ expectations for the federal funds rate, which is set by the Fed and charged on overnight interbank loans.

As of June 13, three-month LIBOR was 69 basis points higher than the OIS rate, meaning the spread was 69 basis points. That’s down from a high of 90 basis points in April, but well above the average of 19 basis points over the past five years.

In Greenspan’s eyes, financial markets will return to normal when the spread shrinks to 25 basis points, about where it stood on Aug. 8. That’s when the credit crisis began in earnest.

At the magic 25-basis-point level, Greenspan says, “we will learn this crisis has come to an end.”

Greenspan says rising inflation will test the Fed’s independence during the next few years. Fed officials will have to exert “increasing pressure” on money supply to quell inflation. "As a result, you will see interest rates rising,” Greenspan predicts.

My comment: If interest rate rises slower than inflation, I still favour commodities. If interest rate rises faster than inflation, then I'll switch to cash and bond.