ETF Securities Research Blog

Anatomy of the raising LIBOR

When US interbank lending rates spiked higher without a corresponding official rate rise, investors appeared primarily concerned about liquidity risk in the banking system. However, we believe the rise of the 3-month interbank rates (LIBOR) reflects higher counterparty risks – rising bank stress – rather than a rise of liquidity premiums.

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Reforms of the Money Market Funds (MMFs), announced by the SEC in July 2014, raised concerns about the liquidity as MMFs are major players in the US money market. New regulation intended to mitigate outflows from MMFs during any future period of market turmoil. The liquidity premium – the difference between the rate on 6-month certificates of deposit (CD) and the equivalent term LIBOR rate – increased along with the uncertainty of the impact of the reforms. However, ahead of the October 2016 implementation, liquidity premiums reverted to prior levels as liquidity moved out of Prime MMFs (US$236.8bn outflows) – funds invested in short-term securities – and into Government MMFs (US$259.6bn inflows) – funds invested in Treasuries, US Agencies and cash – which are exempted from the new rule.

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Although liquidity premiums remain depressed, several measures highlight rising credit risk in the banking sector. The recent increase of the LIBOR-OIS spread – gauging the health of the banking system –  reflects changes in risk premiums rather than in liquidity premiums. Accordingly, when LIBOR diverges from the OIS rate (the rate that banks borrow money from the central bank) it shows that banks are paying a greater risk premium on loans from other banks than they are from the Fed.

Another indicator of rising banking sector stress is the TED spread. The widening of the TED spreads – the difference between LIBOR and US T-bills – indicates that risk premium of the banking sector is rising relative to that of the US government. While the current level of the TED spread of 78bps (from 25bps in mid-2015) suggests banks are facing increasing pressures, the situation is still far from the intense market stress on September 2008 where TED spreads exceeded 250bps.

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Lastly, investors’ perception of increased credit risk seems limited to the banking sector as the spread between the 6-month corporate bond yield and 6-month T-bill has been fairly stable since 2012.

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