A rise in LIBOR rates is enough to rouse flashbacks to the dim days of the global financial crisis. But today’s rise in LIBOR is not a signal of credit stresses in the financial sector. It derives from another source: impending regulatory changes to U.S. money market funds (MMFs).
The reforms, adopted by the Securities and Exchange Commission in 2014, go into effect Oct. 14 of this year. The new rules will change the structure of money market funds by moving from a fixed $1 net asset value (NAV) to a floating NAV for institutional “prime” money funds, and imposing potential redemption fees and suspensions in the case of some other MMFs.
Normally, increases in LIBOR are associated with Federal Reserve (Fed) policy rates and expectations. The chart below shows that LIBOR increased late last year in anticipation of the increase in Overnight Indexed Swap (OIS) rates (which track expectations for Fed policy). The LIBOR-OIS spread is a commonly used measure of credit risk within the banking sector. Of course, the Fed ultimately did raise rates last December.
LIBOR increases in July, however, occurred without much change in expectations for Fed policy. This might be interpreted to reflect concerns over bank credit quality, yet other measures of financial credit sector risk declined in July. Hence, the widening in LIBOR appears to anticipate the MMF reforms.
The looming regulatory changes have prompted large shifts in MMF assets out of prime funds, which invest primarily in corporate debt securities, and into government funds, as shown here:
In addition to the realized outflows, uncertainty over future flows out of prime funds magnifies the market impact. This uncertainty has fund managers increasing liquidity and shortening maturities as Oct. 14 approaches. The result is a decline in the supply of short-term (i.e., three-month) funding in the corporate financing market, and a rise in borrowing costs.
While the current rise in LIBOR rates comes from an unusual source, it is no less impactful to the global bond outlook. Higher short-term borrowing rates affect longer rates in the United States, for example, and foreign investors looking to hedge currency risks now face higher costs of hedging.
The outlook for LIBOR post-reform depends on the level at which assets stabilize in prime funds. In the near term, assets in prime funds are likely to continue their decline. This is both a function of the regulatory changes and economics: The drop in prime fund yields relative to government fund yields encourages investors to shift into government funds. Post-reform, however, prime funds will be able to reestablish a yield advantage vs. government funds by extending maturities in corporate debt. That yield advantage could potentially attract flows back into the asset class.
Until then, we expect LIBOR rates will continue to be pressured higher, with the market pricing around 15 basis points of increase. Longer term, we expect Fed interest rate policy to reassert its influence over the direction of LIBOR. At this juncture, a 25-basis-point Fed rate hike by year-end cannot be ruled out. That implies a total potential LIBOR increase upwards of 40 basis points, though as flows return to prime funds, that amount may subsequently be lower.
For investors, in a world of zero and even negative interest rates, rising LIBOR rates represent more of a future investment opportunity than a traditional warning sign.