The Dow Jones Industrial Average soared more than 900 points Monday, the largest one day move in history. So what. It is easy to get drawn into a daily drama of the stock market, especially the Dow index. But remember the Dow is only 30 companies out of the thousands of publicly traded equities. In the grand scheme of things, it is not the best barometer for the health of the market. Conversely, Libor rates and commercial paper volume are virtually unknown to casual observers of Wall Street, but provide a far more important measure of the underlying health of the credit markets, the lifeblood of the financial system. In a healthy financial system, banks happily lend to one another without fear about whether competitors will continue to be viable institutions. The London interbank offer rate, or Libor, is the amount that the banks charge one another to borrow. If this figure moves up, banks are indicating their unwillingness to lend. Three-month Libor has been hovering around 4.75% a full 3% ahead of where it was prior to 2007. If this number begins to come down, it is a good indication that banks are beginning to see fear subside.
The Federal Reserve has been pumping huge amounts of cash into the banking system in the hopes of sating cash-hungry banks and encouraging lending. That hasn't solved the problem. Now the federal government is mulling a plan similar to the U.K.'s decision Monday to inject 37 billion pounds ($64 billion) to boost their Tier-1 capital ratios of Royal Bank of Scotland ( RBS), HBOS and Lloyd's TSB. In exchange the British government will take equity positions in the banks.
Treasury Secretary Henry Paulson summoned the big banks including JPMorgan Chase ( JPM), Goldman Sachs ( GS), Morgan Stanley ( MS), Citigroup ( C) and Bank of America ( BAC) to talk about the government's efforts to spur liquidity. Unfortunately you can lead a bank to liquidity, but you can't make it lend. The next area to keep an eye on is the seven-day commercial paper rate and the volume of commercial paper issued. Commercial paper is essential to credit cards, car loans and even companies making payroll. Commercial paper is not backed by collateral and only issued by companies big enough and solid enough to give investors comfort in buying the instruments. The system is known to be able to flush out unstable entities and as a result has seen very few defaults. This market has contracted to $1.55 trillion for the week ended Oct. 8, according to the Fed. The weekly average in 2007 was more than $2 trillion. In addition to fewer issues, the commercial paper market is suffering from the rate companies are being forced to pay to entice investors to buy it. Normal levels had been around 2.5%, yet the seven-day rate is trading at roughly 4.5%. As the rates come down, companies will be able to return to the market for their financing needs. The U.S. bond market was closed Monday for the Columbus Day holiday, so it is difficult to gauge any improvement among the credit market amid equities' 936-point explosion. But before getting too excited about Monday's rally, keep an eye out Tuesday morning for these more telling indicators. Stop watching the Dow.