What next for Li­bor rates?

Financial Mirror (Cyprus) - - FRONT PAGE - By Will Denyer

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%.

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