Libor’s Relevance Rising Again When It Comes to Fed Rate Outlook

Barclays $451 Million Libor Fine Paves the Way for Competitors
Photographer: Simon Dawson/Bloomberg

After dropping off the radar since its fall from grace during the financial crisis, the rate at which banks say they borrow from one another may be becoming relevant again.

The three-month London interbank offered rate, known as Libor, rose this week to a more than two-year high. That may be foreshadowing an interest-rate increase by the Federal Reserve by the end of year while other indicators such as futures provide more skeptical outlooks on the timing of tightening.

Minutes released Wednesday from the Federal Open Market Committee’s April meeting show policy makers are weighing incoming economic reports as they debate raising borrowing costs for the first time since 2006. Libor is driven in part by the outlook for the Fed’s policy rate as well as the level of credit risk in the banking sector, which is why it is at a premium to the funds rate.

Derivatives show traders are only giving 50 percent odds of an increase by end of the third quarter. At the same time, three-month Libor was 0.2835 percent Wednesday, up from 0.2329 percent six months ago and the highest since March 2013. On Thursday the rate fell to 0.282 percent.

“About half the rise we’ve seen is due to changes in the Fed rate expectation component,” said Joseph Abate, strategist at Barclays Plc in New York. “Whatever the exact timing of the Fed increase, we are getting closer to it. And the balance of power in money markets is shifting toward the providers of cash as investors see a greater chance of September hike” and want to be compensated for that.

Libor Scandal

There is a more than 50 percent chance the Fed lifts its record-low policy rate in October from a range of zero to 0.25 percent, according to Bloomberg calculations using fed funds futures contracts. The central bank will increase its benchmark rate in 7.3 months, a Morgan Stanley index showed on Wednesday.

The rise in Libor may prove an additional catalyst to reducing liquidity in fixed-income markets. Even as Fed easing has left trillions in excess reserves in the banking system, Treasury yields have seen broad swings in 2015 as regulatory pressure causes banks to step away from market making.

“It cannot be unnoticed, the persistent rise in Libor, and how that might greatly affect overall liquidity,” said Jeffrey Snider, chief investment strategist at West Palm Beach, Florida-based Alhambra Investment Partners LLC.

Intercontinental Exchange Inc. took over last year as administer of Libor, which was previously managed by the British Bankers Association. The BBA and its daily Libor fixing in the years following the financial crisis came under scrutiny by regulators across the globe amid allegations that traders manipulated key market benchmarks for profit.

The scandal has impaired confidence in the Libor rate, a benchmark for more than $360 trillion in securities worldwide, and made some bankers and investors seek alternative interest-rate measures that are based on actual trades rather than submitted quotes.

Libor’s rise “is not necessarily showing that the banks can’t get funded,” said Abate. “It’s a situation where the banks and lenders are disagreeing where they should be pricing liquidity. The trends toward higher Libor should continue.”

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