What next for Libor rates?
The Federal Reserve has not hiked rates this year, but that has not stopped funding cost for US companies and foreign banks from rising. While risk-free rates have barely budged, 3-month LIBOR is up 30bp YTD from 0.6% to 0.9%. This widening of short-term credit spread stems from (i) stress in Europe’s banking sector, and (ii) fund flows ahead of a regulatory overhaul of US “prime” money market funds, which took effect on Friday. The good news is that this widening of spreads is likely over, or nearly over. The concern is that firms will still be left with higher funding costs which must be properly accounted for.
As of Friday, prime money market funds—which invest in commercial paper rather than government bills—must use “floating” net asset values instead of a fixed $1/share, and may charge redemption fees or even put up “gates” during times of stress. The reforms aim to make money markets more stable; but they also attempt to remove the US government’s implied guarantee stemming from the 2008 crisis. When the original money market fund, established in 1971, “broke the buck” in September 2008, the US government rushed out an insurance program to guarantee the $1/share price in order to halt redemptions. It worked, but after closing the program in 2009 the government wants to remove the assumption that it will again defend the value of such funds—hence the new floating NAVs and redemption barriers.
To avoid potential redemption fees and NAV fluctuations, $1 trln worth of assets have moved from prime money market funds to government money market funds, according to Bloomberg estimates. These flows, along with European banking woes, have caused spreads to blow out. The good news is that this widening process is probably done and dusted—for two reasons: 1) much of the shifting of funds has likely already occurred, and 2) the Fed’s US dollar swap lines with foreign central banks provide a ceiling on short-rate spreads not far above today’s levels. Since 2011, these swaps have been priced at 50bp over OIS (OIS being the fixed rate for an overnight swap against the Fed Funds rate). Three-month Libor (i.e. the average rate at which banks are lending to each other) is now 40bp over OIS, so that spread should only be able to widen another 10bp before the central bank release valve kicks in. This cap was shown to work during the eurozone crisis of late 2011-12 (see chart). The caveat is that these Fed swaps have a maximum duration of three months, so longer-term rates might see a further widening of spreads. Still, my base case is that the effect will be to anchor spreads across the short end of the curve (if needed the Fed would probably extend the maximum duration).
The bad news is that short-term credit spreads are unlikely to fall back to levels that were typical before the overhaul of money market rules. Jerome Scheider, who heads Pimco’s short term and funding desk, recently noted: “It’s important to remember that this is not simply a market reaction to a piece of data, but a structural reform that will change the way most investors allocate their cash liquidity over time.”
The implication is that this structural rise in the cost of short-term funding should be factored into economic analysis and capital asset pricing models. Over the last year, I have devoted significant research effort to monitoring the relationship between the cost of capital and its return, as a tool for mapping the economic cycle and adjusting portfolio risk. To date, this effort has relied on three proxies for the cost of capital (real rates on long-term corporate bonds, treasury bonds, and the Fed Funds rate). The chart here updates this analysis by incorporating Libor into the calculation. It is noteworthy that the spread—between the current rate of ROIC for US corporates and 6-month LIBOR—has deteriorated more than other spreads used in the model. Hence, the overall impact of incorporating this spread into my portfolio model has been to tick down the recommended risk (equity) exposure to a tad below 40%.