As detailed in a Bloomberg article last week, a regulatory overhaul due to take effect October 14th, targeting money-fund industry has lead to a sharp increase in LIBOR as banks raise the cost of funding. The summer trading period was marked by surprisingly low volatility in the markets and strong cross asset correlation; this could be the explanation.
LIBOR rates have been rising similar to late-2015 before the FED hiked for the first time, but with uncertainties persisting regarding timing of the next FED hike, the inter bank rates have done a pseudo-rate hike.
This may lead to the FED potentially holding off their next rate hike until December, as a tightening in financial conditions has already occurred. It is also possible that after seeing the tightening in LIBOR without significant market reaction, the FED may be prompted to hike to maintain their credibility. More colour on this question will be available after the FED’s Wednesday meeting.
The Dollar (DXY) has maintained a strong holding pattern as seen below this summer. While US economic weakness was highlighted with weak GDP growth for the 3rd straight quarter and lackluster PMI failed to sink the dollar rally, even as further divergence from dollar fundamentals continues.
This could be another consequences of the prime fund unloading impacting the LIBOR rate. Short term interest rates, shown below by the 3M T-Bill have been moving in the same direction, potentially attracting more dollar demand in the US treasury market.
Concurrently, it seems that the low-yield environment may have been caused by the move in LIBOR, stabilizing both equity and debt markets throughout the summer.
Excerpt from Bloomberg:
“Amid the tumult, money-fund assets have held steady because most of the cash leaving prime and tax-exempt funds has streamed into less risky offerings focusing on Treasuries and other government-related debt, such as agency securities and repurchase agreements.”
The opposite effect can be seen in the long end of the curve with 30-year yields touching all time lows and staying there earlier this summer. This was the case until central bank comments in the beginning of September corrected the move.
Gold was also likely affected by strong dollar and a short term yield bump, failing to breach post-Brexit highs even as growth data continued to deteriorate.
What can we expect next?
“Libor may stabilize after mid-October because prime funds may begin to increase purchases of bank IOUs, although the risk of a Federal Reserve interest-rate hike by year-end will keep it elevated, said Seth Roman, who helps oversee five funds with a combined $3.2 billion at Pioneer Investments in Boston.”
The market is currently pricing in a ~20% chance of a FED rate hike in September, largely complicated by weak economic data, a tightening of financial conditions(LIBOR) due to structural changes in the market and election uncertainty. As the LIBOR rate rises further and stabilizes I will be monitoring aforementioned asset classes for a reaction.