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As indicated in a post last week the rates markets have developed a life of their own, in the US that is. While Libor settings in other currency areas are adhering to their respective monetary policies and remain stubbornly low, and negative for that matter, such as in the eurozone and in Japan, or are dumping due to latest central bank actions like in the UK, the Libor settings in the US are flying high, literally.
Across the curve Libor rates have more than tripled from late 2014. 6 months are being set at 1.21% now, 3 months at around 80bp, and the 1 month has now eclipsed 50bp. In contrast, Euribor is deep in the red in all tenors, Yen Libor is negative in 1 and 3 months, and Sterling 6 month Libor crashed from 75 to 50bp, commensurate with the Bank of England’s recent rate cut.
So why Libor, and why the US? The pundits are quick to give an all clear and calm everyone down, by stating that there isn’t any credit deterioration or liquidity crisis among banks to speak of. Rather, it is good old regulations that are causing the damage. There are numerous commentaries flying around, claiming that rates have risen mainly courtesy to changes in SEC regulations that are expected to make money market funds safer.
From October, those money funds that invest in non-government debt instruments will be able to suspend redemptions temporarily in crisis or crunch times, making it more difficult for investors to get their money back. So, for the funds it will be less attractive to buy paper from corporates as well as financial institutions, i.e. a reliable source of funding for the banks is being choked off and they will be more dependent from borrowing from each other.
The second reason given concerns the ICE benchmark administration and the methodology roadmap for how Libor will be newly defined. The ICE is likely to include more types of lenders beyond the interbank market in its calculation and to be more focussed on actual transactions weighted by size. Equally here, the pundits claim it is such action that is pushing the Libor measurement up.
Okay, so far so good. These are all plausible explanations. However, the fact remains that financing costs have been going up, and significantly. Borrowers who have financed their liabilities on the basis of 6 month Libor have seen their cost go up by almost 100bp in 18 months. That’s not nothing. To them, it very much feels like the Fed has already taken 3 or 4 steps in hiking Fed funds, and not just one.
The world is only waking up to this era of higher rates on the floating end of the spectrum, which has happened stealthily but still surprisingly. And it will affect everybody going forward, whether it is corporates with limited cash flows, consumers in debt or non-agency mortgage takers. CLOs are seeing their pay-outs increasing which is in turn putting pressure on the loans of their underlying businesses.
Libor is at the heart of the economy and our financial system. It is filtering through every financial channel and has already repriced debt on the short end. It is almost like the Fed can literally do whatever it feels like, the market is the market, and it doesn’t look back. The cheap money we have grown so accustomed to is a thing of the past. The dollar carry trade, or what’s left of it, is also gone for good.
So the Fed finds itself in a bit of a pickle. The outrageous Q3 nowcast estimates of the Atlanta Fed are finally coming down and still aren’t anywhere near reality. Retail sales missed on Friday. Core PPI was softer than projected. Consumer inflation expectations are drifting lower. Business inventories increased more than expected. And the Empire Fed is back in contraction mode overnight.
And then rates are up by a significant margin despite the Fed still being on hold, whether this is caused by the government’s own regularity doing or not. What a bummer…! And what a predicament Yellen and Co must find themselves being in. Should they hike and chase the market, which wouldn’t exactly be leading by monetary policy example anymore. Or will they be forced to ease at one point, hoping the market will revert to Fed rule?
This could easily become a dilemma for US central banking. Some borrowers aren’t without alternatives though. Compare 6 month Libor at 1.21% to 10 year Treasury yields at 1.50% and you will know what to do in this ultra-flat yield curve scenario. You might even want to wait a little longer with your funding, to time an entry into further declining long yields.
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