It's not over.
Drama unfolding deep in the bowels of the financial system looks set to continue after a brief pause in August, according to new analysis from TD Securities (USA) LLC.
The London Interbank Offered Rate known as Libor surging from 61 basis points at the start of the year to 84bps at the end of August, the highest since the financial crisis. The move comes ahead of the Oct. 14 deadline for reform efforts that will see money market funds — a $2.7 trillion market that forms an important source of short-term funding for banks — build up so-called liquidity buffers and install redemption gates, among other measures.
The looming deadline means that prime money market funds which typically buy the short-term IOUs known as commercial paper (CP) issued by banks and other companies, have been shifting into government securities in anticipation of investor redemptions or as they try to build up the liquidity buffers that will be required in just over a month's time.
The exodus has helped push up the cost of corporate and bank funding earlier in the year, sending CP and Libor rates soaring.
After a brief moderation in August, the trend looks set to continue, according to TD analysts led by Priya Misra.
They point to a divergence between stabilizing money market rates and the still-rising cost of obtaining U.S. dollar funding through the derivatives market. While increases in commercial paper rates and Libor have stalled in recent weeks, the cost of swapping currencies such as the yen or euro into U.S. dollars using the so-called cross-currency basis swap has jumped to as much as 155 and 116bps, respectively, suggesting continued strains in the dollar funding market as banks scramble to replace a funding hole left by exiting prime money market funds.
"Even though commercial paper rates have not risen over the last few weeks, the implied cost of unsecured dollar financing has increased steadily according to the cross-currency basis swap market or the FX forwards market. These levels are almost all higher than the Libor fixing [which currently stands at 84bps]," the analysts said in a note published late on Wednesday. "While the two markets are not identical and there are differences in terms of domestic funding costs, margins and credit lines with the basis swap market, we believe that these higher implied rates hints at the ongoing pressure for dollar financing by non-U.S. banks."
TD expects $200 to $300 billion to leave prime money market funds before Oct. 14, which could help fuel further increases in Libor. Higher money market rates would mean a tightening of financial conditions even if the Federal Reserve opts not to raise benchmark U.S. interest rates in September, with far-reaching consequences for players as varied as big Japanese banks dealing with dollar funding costs, U.S. home owners, and companies in emerging markets such as China.
"Over time we believe that these two markets should converge, implying that Libor should fix higher," the TD analysts concluded.