While U.S. Treasuries and global interest rates have been stable for quite some time, strange things are happening in the LIBOR (London InterBank Offered Rate) markets, where many of the world’s leading banks borrow from one another on a short-term basis.
Three-month LIBOR rates today are higher than they were in 2011 (see chart).
In case you don’t remember, in 2011 the markets were preoccupied with the prospect of the Eurozone breaking up and taking the European financial system down with it. Only massive intervention by the European Central Bank (ECB) helped us get over that situation.
So why exactly is LIBOR up so much now? And if there is panic in the LIBOR markets, why are other financial markets so sanguine?
Bank Dollar Needs Driving LIBOR
Investors may be thankful that there is a “non-distress” explanation for current happenings in the LIBOR markets. It has more to do with money market reform rules issued by the U.S. Securities and Exchange Commission (SEC) than anything else. The situation should resolve itself by October, when the SEC’s rules are scheduled to be fully implemented. Further, due to some borrowing infrastructure already in place among the Federal Reserve (Fed), the ECB and other large central banks, the situation can be controlled before it gets out of hand.
The primary driver of the increase in LIBOR is the dollar funding needs of European and other non-U.S. banks. They have typically borrowed these dollars in U.S. money markets from U.S. money market funds.
However, as a result of the SEC’s money market fund reforms (which include floating NAV (net asset value) and gates or fees for institutional prime monetary market mutual funds), a substantial amount of assets in today’s prime money market funds are being moved to government money market funds. This newly transitioned money, therefore, may only be invested in government instruments and is not available to fund non-U.S. banks in money markets. As a result, there is a big mismatch between the supply of the dollar funds and the large demand for these funds from international banks. LIBOR rates have increased quite a lot as a result.
To deal with the current shortage of dollar funds, these banks have been borrowing in other markets and in other currencies (which are quite attractive due to the negative rates for ECB deposits left by European banks) and hedging the ensuing currency risk in the cross currency foreign exchange markets. Unfortunately, as a result of this huge demand for cross currency hedging, cross currency basis spreads have widened as well.
LIBOR May Stay High
Our expectation is that this is a temporary situation. When the SEC’s money market reforms are fully implemented in October, LIBOR levels may normalize a bit. While LIBOR should come down some in the fall as a result, LIBOR levels are still likely to be higher on a sustained basis, as money market reform will reduce the amount of funds available to these banks for quite some time. Bank loan funds are likely to be a potential beneficiary of this change. International banks, whose dollar funding costs may be higher, are the potential marginal losers.
Furthermore, there is a natural peak as to how high LIBOR rates can get. At various points during and after the 2008 financial crisis, there were visible strains in the dollar funding markets. To contain the situation, the Fed has established dollar swap lines to other global central banks to be lent, in turn, to their domestic banks.
Therefore, if LIBOR rates rise too much, European banks may have incentive to borrow from the ECB against these Fed-established swap lines rather than fund themselves in the U.S. money markets. They have been somewhat reluctant to do that due to the potential reputational damage such borrowing may cause. Nevertheless, the Fed swap lines provide a natural safety valve to this funding anomaly.
The bottom line: Money market reforms, not international bank distress, have caused an unusual spike in LIBOR rates―something forward LIBOR-based markets, such as Eurodollar futures, had actually priced well before the recent increase in spot rates.
The spike may fade by autumn but LIBOR rates are likely to be modestly higher on a permanent basis. In my view, funds that invest in LIBOR-based products may be a beneficiary of this move.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Eurozone investments may be subject to volatility and liquidity issues.
An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in them.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.