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LIBOR Moves Higher

Posted by Jeremy Merchant on Sep 1, 2016 5:13:24 PM
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Jeremy_branded_small_with_words.jpgIn July 2014, the Securities and Exchange Commission (SEC) issued new regulatory rules governing money market mutual funds. These changes, which will become effective on October 14th, 2016, will establish a new framework for this asset class.

Going forward, money markets will be placed in the following categories, some of which will have floating Net Asset Values (NAV). In addition, some classifications will be subject to shareholder liquidity fees and redemption gates during periods of severe economic stress.

According to the new rules, money market mutual funds will be categorized as follows:

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Rest assured that we have been monitoring these changes closely and have already made the necessary changes in our money market holdings. As such, the portfolios are currently invested in a government money market fund that will maintain a stable NAV, and the portfolios are not subject to liquidity fees or redemption gates.

Nonetheless, these money market regulatory changes have resulted in some unintended consequences. As you can see in the chart below, the federal funds rate and the 3-month LIBOR rate are highly correlated and the spread between the two has historically been less than 25 bps. In fact, only during times of economic stress (like 2008) has the spread been materially greater than 25 bps. As it stands now, the spread has risen to almost 50 bps, which is double its historical spread.

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Under normal circumstances, we would be looking for issues in the credit markets, however, most portfolio managers agree that this spike in LIBOR is tied to the upcoming money market regulatory changes. These regulatory changes have caused investors to begin gravitating to Government and U.S. Treasury Money Market funds with a stable NAV. Since these money market funds only invest in government securities, it has decreased the demand for other traditional holdings like short-term bank debt. This reduction in demand for bank financing from money market funds has forced banks to bid higher rates in the LIBOR market.

This increase in LIBOR could quickly lead to tighter financial conditions, as LIBOR is also the base rate to which many consumer/commercial loans are tied. Credit card, student loan, and commercial loan rates, which generally have quarterly resets, should all adjust higher soon, raising debt service costs. In addition, as the money market deadline gets closer, LIBOR could easily increase further as asset flows intensify. Another consequence could be a shortage of U.S. dollar funding as monies flee prime money market funds. Prime money market funds are a major funding source for commercial paper and certificates of deposit. If this indeed becomes an issue, banks as well as other institutions will need to come up with alternative sources of U.S. dollar funding. If these international institutions are unable to find an adequate source of U.S. dollar funding, then higher LIBOR rates may become the norm moving forward.

Please contact us at (972) 684-5923 if you have any questions.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates