Central Banks, LIBOR, & The Road To Ruin

Authored by Tuomas Malinen via GnSEconomics.com,

The sudden and fast rise in the London Interbank Offered Rate (Libor), has stirred a lively debate. Its suggested drivers include rising outflow pressures on dollar deposits, an increase in short-term Treasury bill issuance, elevated credit spreads for banks and risk premiums for uncertainty towards US monetary policy. While all these deserve merit, we argue that the most prominent driver is the drastic change in policy of the central banks.

Quantitative tightening, or QT -program of the Fed, which started in earnest in January, has been altering the landscape of financial markets since October. In October, the Fed unwind first patches of Treasury bills and mortgage backed securities from its balance sheet without repatriating them with similar amounts of new assets. In January, the pace of unwind accelerated to $20 billion a month.

QT is such a game-changing event for the financial markets for the simple reason that it is a mirror-image of the asset purchase program, or quantitative easing (QE), which had a large effect on the financial markets around the globe (see, e.g., thisthisthis and this) and on banking. QT programs will alter the risk allocation, which is now already visible in the stock markets and in the Libor.

The Libor fallacy

The Libor is a compilation of responses of banks to the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” Libor is thus an estimate on short term rates on uncovered loans banks use to settle transactions in their respective currencies as well as transactions denominated in other currencies. It tends to follow the interest rates set by central banks, which determines the rate financial institutions can get money short-term (over-night).

When the Libor rises notably faster than the risk-free rate (see Figure 1), it signals that the banks do not trust each other so that they would extend any longer inter-bank loans. During the 2008 crisis, Libor was in practice discontinued, because the long-term lending ceased completely. Now, the three month Libor spread over the over-night index swap (OIS) has reached levels not seen since May 2009. What makes this particularly puzzling is that other commonly used stress metrics of the credit markets, like the TED spread (3M Libor vs. 3M US Treasury bill), have risen only mildly.

Figure 1. 3-month London Interbank Offered Rate (LIBOR) and the Effective Fed Funds Rate. Source: GnS Economics, St. Louis Fed

QT, risk premium and the financial markets

QE created an over-demand for investment grade assets and thus an excess liquidity environment in the financial markets by introducing a persistent buyer (the central bank). The over-demand led to a hunt for yield, spread compression and to inflation across the asset universe (see Figure 2).  Moreover, because QE forced banks to hold high supply of reserves, they bid up various securities and made additional loans until the marginal benefit of assets in banks’ portfolios were restored to balance. This changed the reserves, asset allocation and lending in the whole banking system. Because of the vast quantities of excess reserves and liquidity in the banking system, the risk of lending to other banks was minimized.

QT will create an over-supply of investment grade bonds leading to a flight to quality, spread dispersion and asset price deflation (see Figure 2). QT removes the excess liquidity from the financial markets created by the QE by introducing a persistent seller. This will balance the risk premium, that is, the return on an investment is expected to yield more than the risk-free rate of return. It also alters the asset portfolios of banks and eventually start to shrink their reserves. This affects consumer and business lending and the lending activity of banks in the inter-bank and money markets. Risk pricing returns and rates rise, which is now visible in Libor.

Figure 2. The causative channels of quantitative easing and quantitative tightening. Source: GnS Economics

The acceleration in Libor-OIS three month spread started in November 2017 by a rapid uptick in Libor, approximately a month after the Fed started its QT, rate (see Figure 1). On the question, about why the other measures of financial stress have not risen in pace of Libor, the answer may lie in the dual nature of the QT -program (see Figure 2). When the Fed rolls off assets from its balance sheet, it creates an over-supply of US Treasuries thus lowering their price and removing the excess liquidity from the financial markets. If there is mistrust in the money markets, the receding liquidity makes it visible again. This leads to rising yields of the US treasuries and to rising Libor -rates. Therefore, because QT does not alter the OIS rates set by the Fed but it does increase the yields of US treasuries, the exposed mistrust in the money markets may widen the Libor-OIS spread but leave the other stress metrics, like the TED spread, unchanged.

After the 2008-crisis, it was the intention of the central banks to keep the money market rates low, that is, close to over-night swap rate using QE and other non-standard monetary policy measures. Now, as the blanket of central bank liquidity recedes, it will reveal the real cost and the risk in the inter-bank lending. We thus face the question whether the money markets really recovered after the crisis? If one looks at the European banking sector, the conclusion is that they didn’t. The credit default swaps of banks have also started to rise although from very low levels, thus signaling increasing stress.

The road to ruin

The return of market volatility and the rise in Libor signal that the balance sheet normalization of central banks will not go smoothly. Tremors are already felt in the stock market even though the Fed has slashed just around 1.5 % of its asset holdings.  One can imagine what will happen when the ECB and the other central banks hop the wagon. Because of the multitude and the self-enforcing effects of QT on the financial markets, a complete capital market meltdown is not some distant possibility. It is a frightfully likely scenario.

However, while the timetable, announced after the FOMC meeting in September 20, states that the Fed should have slashed around $90 billion of its asset holdings by the end of March, they have actually shrunk by only $71 billion (and by only $5 billion last month).  One can only speculate what has been the reason behind this, but we can safely assume that the market turbulence has played some role. For the asset markets, a lot depends on this month, because the pace of unwinding should quicken to $30 billion per month.

Despite the tinkering by the Fed, the fact remains that central bankers are between a rock and a hard place. Not trying to normalize their balance sheets and tighten the monetary policy would mean that they would have no (reasonable) means to fight the next recession. Tightening, on the other hand, is likely to crash the asset markets and possibly trigger the recession. Neither of these options will be beneficial for the asset markets. Thus, it is best to buckle up.

Comments

founthead spastic_colon Sat, 04/07/2018 - 01:06 Permalink

The US treasuries market :
Supply Side - Tax Cuts and Increased spending leading to high Fiscal Deficit, resulting in more than $1.2Tr. in borrowings by the US Govt. (just at the Federal  level) per year.
Demand Side -
1. The Fed Reserve starting to unwind its bloated balance sheet of $2.3Tr USTs (plus another $2.1Tr in MBSes)
2. China threatening to unwind its $1.2 Tr position in USTs as part of the looming trade war. The "allies" who traditionally come to the rescue (Swiss, Belgium, Norway, Saudi CBs/Sovereign Funds) have already being doing so, so not sure how much of additional hit will they be willing to take on behalf of the US.
3. But the biggest factor no one is talking about is the US Social Security winddown of the UST purchases. In the previous decades, the working population of the US contributed to Social Security, which far exceeded the payouts made to Retirees/On-the-dole population. Thus about 45% of all USTs offered were taken up by the SS (called non-marketable USTs since they could not be traded on the open market). Now the demographic bomb of retiring Baby-Boomers is ensuring that SS will be doling out more than it receives by 2020! Thus from a Net big purchaser, SS is turning into a Net big Seller of USTs - and this, unlike the Fed, or Chinese case, is totally non-discretionary!!!

So, the end result? Increasing Yields on the USTs. Add increased inflation due to the looming Trade Wars, and maxed-out Debt levels (Public, Corp. and Household) and you have the perfect storm. Watch out for UST 10 Yr yields to cross 3.00% and settle down (with obligatory beer and popcorn) to watch the shit-storm.....

In reply to by spastic_colon

withglee Fri, 04/06/2018 - 13:04 Permalink

In a "real" money process, INTEREST collections perpetually match DEFAULTs actually incurred. It's an automatic negative feedback system that delivers stability and guarantees zero INFLATION.

LIBOR is one of the knobs the money changers turn to run the farming operation they call the business cycle. The money supply knob is another. With those two knobs, they have all traders by the short hairs.

A "real" money process has neither knob.

The Ram Fri, 04/06/2018 - 13:08 Permalink

The CB's are backed into a corner.  Increasing LIBOR rates will help collapse the ponzi very quickly as all lending is reflected in these rates.  LIBOR goes up....voila....increasing auto rates, student loans, mortgages, etc.  It's really the needed medicine as bitter as it may taste for those who need to borrow money.  

Herdee Fri, 04/06/2018 - 13:35 Permalink

Don't worry, U.S. government deficits are still the biggest risk, they'll back off and lower rates. It's basically out of control now so look for QE4 and the all out, obvious monetization of debt at all costs. Until you see the U.S. government balance their budget, don't live in a dream land. They're staying at The Roach Motel.

Quantify two hoots Fri, 04/06/2018 - 21:01 Permalink

The bottom 3 are all U.S. protectorates.

The Compact of Free Association (COFA) is an international agreement establishing and governing the relationships of free association between the United States and the three Pacific Island nations of the Federated States of Micronesia, the Marshall Islands, and Palau.

In reply to by two hoots

Kendle C Fri, 04/06/2018 - 14:03 Permalink

"...the fact remains that central bankers are between a rock and a hard place." The BIS and Rothschilds have turned on the milking machine. Orwell said, "...imagine a boot stamping on a human face - forever." This article attempts to absolve the banks by implying they're not actively fucking us.

currency Fri, 04/06/2018 - 14:18 Permalink

The Fed and ECB leadership Bernanke/Yellen, Drahai/Greenspan all the main cause of the problems they did not fix the system when they had a chance they simply believe in printing money and flood the system drop $$$ from Helicopters and hope that asset prices would rise enough to take care of the issues. Each time they had a chance to take the necessary steps they did not they kick the can down the road and caused more and more and larger bubbles.

This coming collapse will be the worse in the past 200 years.

itstippy Fri, 04/06/2018 - 14:23 Permalink

Banks are afraid to loan to each other for three months, so they demand higher interest to cover the risk.

Banks are willing to make low interest deep subprime auto loans on used vehicles.

Deep in the bowels of the banking world there are meetings underway of very nervous, overweight, tanned, tailored-suit-wearing assholes.  Their perspiration is overwhelming their Arid Extra Dry and expensive mens' cologne.  Tonight they'll go home, overindulge in fine Scotch whiskey, and try to get some sleep under the imported linen sheets.  Tomorrow there's another meeting.

Some of us will monitor their anguish from a distance, reading articles and posting comments on ZeroHedge.  Something big is afoot; it'll be highly entertaining for those who have prepared.  

cryptomonk Fri, 04/06/2018 - 14:57 Permalink

I call bullshit. They are all loaded with a hefty amount of excess reserves and getting even interest on that from CBs. Why would they all of a sudden need reserves and cause libor jump? It's a game to stripe off those poor debtors with a variable interest rate based on libor.

Ron_Mexico Fri, 04/06/2018 - 15:47 Permalink

To paraphrase Donald Rumsfeld:  "You go into the recession you have, not the one you wish you had."

Historians will paper over all the mistakes made during the BHO administration, which were numerous and ignorant.