Mike Spychalski, CAIA
This week’s chart of the week looks at the recent spike in the London Inter Bank Offered Rate (LIBOR), which is the rate at which banks charge one another for short-term loans. As the chart illustrates, over the past year the 3-month LIBOR rate has increased from 0.32% to 0.88% (an increase of 0.56%), which is the highest rate for 3-month LIBOR since the spring of 2009. While other measures of short term interest rates — such as the Fed Funds Rate (increasing from 0.25% to 0.50%) and 3-month T-Bills (increasing from 0.01% to 0.33%) — have also risen over the past year, the magnitude of the LIBOR increase is significantly larger and warrants further examination.
Over the past few months, both the Fed Funds Rate and T-Bills have remained flat, while LIBOR has continued to increase steadily (increasing from 0.65% on June 30th to 0.88% on September 18th). During this time period, the spread between LIBOR and T-Bills (known as the TED spread) has increased from 0.39% to 0.55%. In fact, the current spread of 0.55% is higher than the 0.42% average TED spread since the year 2000. This is concerning because historically, an increase in the TED spread has indicated stress in the financial markets. The TED spread spiked in mid-2007 when signs of the financial crisis first started to appear, and spiked again in 2008 as the crisis unfolded. Now that the TED spread is increasing again, there is some concern that this may be an early sign of another financial crisis starting to unfold.
In order to put the recent rise in LIBOR (and the corresponding rise in the TED spread) in context, it is important to look at what has driven these rates higher. Unlike the 2007/2008 financial crisis, the recent increase in LIBOR is not a result of distress in the credit markets. In fact, between June 30th and September 18th, high yield credit spreads (a reliable measure of the health of the credit markets) decreased by 1.4%. And unlike the 2007/2008 financial crisis, the recent increase in the TED spread has been relatively small. While the current 0.55% TED spread is slightly greater than the long-term average, it is well below the 4.63% peak we saw during the fourth quarter of 2008. The recent increase in LIBOR appears to be driven primarily by the money market reforms that went into effect on October 14th that require most money market funds to invest exclusively in U.S. government securities. As a result of this new regulation, more than $1 trillion has moved out of “prime” money market funds, which were allowed to invest in short-term corporate bonds and certificates of deposit tied to LIBOR rates, and into “government only” money market funds. It is unclear whether the increase in LIBOR rates and TED spreads are a temporary phenomenon driven by a supply/demand imbalance or if this is a permanent structural change. Either way, this is something that should be monitored closely in the coming months.
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