A $7-T Event in the World’s Financial Markets Is Looming
$GS, $DB, $JPM
If the London Interbank Borrowing Rate aka LIBOR was a musical artist, or an actor, or a sports team, we will be calling Y 2016 its comeback year.
Not since the financial crisis of Y 2008 has Libor, to which almost $7-T of debt including mortgages, student loans and corporate borrowings, is pegged experienced such a surge.
The 3-month USD Libor rate has jumped from 0.61% at the start of the year to 0.87% currently, a 42% rise ahead of money market reform that’s due to come into effect on 14 October.
The new rules require prime money market funds, an important source of short-term funding for banks and companies to build up liquidity buffers, install redemption gates, and use ‘floating’ net asset values instead of a fixed $1/share price. While the changes are aimed at reinforcing a $2.7-T industry that exacerbated the financial crisis, they are also causing turmoil in money markets as big banks adjust to the new reality of a shrinking pool of available funding.
Some $1-T worth of assets have shifted from prime money market funds into government money market funds that invest in safer assets such as short-term US debt, according to estimates. The move has driven up Libor rates as banks and other corporate entities compete to replace the lost funding.
Now, analysts are debating whether the looming 14 October deadline will mark a turning point for the interbank borrowing rate, as money markets acclimatize to a new reality.
While analysts at Deutsche Bank AG (NYSE:DB) believe that Libor may be poised to tighten when compared to other benchmark interest rates after 14 October. Goldman Sachs Group Inc. (NYSE:GS) thinks Libor will reach a 3.6% by the end of Y 2019 or about 270 basis points more than its current mark.
“We are inclined to think that the midsummer Libor pain has fully run its course, and three-month Libor could begin to set tighter against Federal Reserve expectations as measured by the overnight index swap rate,” Deutsche Bank analysts wrote in a note published late last week.
Complicating such forecasts is the vast array of moving parts involved in money markets. These range from the liquidity operations, currency swaps, and monetary policies of central banks, to the behavior of investors, bank treasurers, and money market fund managers.
Goldman Sachs said that lower Libor may materialize as banks switch to turn to new sources of USD funding, though the bank assumes that interest rate hikes by the US central bank will likely push the rate even higher over the longer-term.
“The trend toward higher Libor could eventually be partially reversed as banks develop alternative funding sources, but this process would likely take months to occur,” Goldman’s analyst wrote in a note published last week. “Further, we expect short-end rates in general to be dragged up as the Federal Reserve resumes its hiking cycle.”
Higher rates are encouraging the entry of new buyers for the short-term debt sold by banks including offshore funds, securities lenders, some bond funds, big companies and even retail funds with excess cash, JPMorgan Chase & Co (NYSE:JPM) analysts said in August.
Meanwhile, assets held by foreign banks in the US have fallen by $440-Bover the past year, according to Deutsche, lessening the need for dollar funding.
“To be sure, none of the factors above is strong enough to bring Libor back lower after next week – especially when a December rate hike has yet to be fully priced,” Deutsche Bank concluded. “But what they do suggest is that FRA/OIS and the Libor bases could have already peaked in this episode.”