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What is Going on with LIBOR?

Posted by Larry Doyle on May 15, 2009 12:47 PM |

Libor (London Interbank Overnight Rate), the cost of borrowing U.S. dollars in the overnight market, is plummeting. What is driving this move and what does it mean? A number of people in global finance are asking that very question. Let me offer my opinion. 

After Lehman failed in September 2008, confidence in banks declined precipitously, counterparty risk soared, and Libor screamed higher as well. 3 month Libor topped out at close to 5%. Historically, Libor is just marginally higher than the Fed Funds rate which is currently between 0-.25%. 

Today 3 month Libor is approximately .8%. This move lower is a clear sign of increased confidence in the banking system, isn’t it? In my opinion, this move in rates is a reflection of the following:

1. a realization that global governments will not allow major money center banks to fail.

2. a reflection of the massive increase in dollars in the system associated with all of the liquidity injected via Uncle Sam’s programs.

Has the drop in Libor coincided with an improvement in the credit markets? No. Despite what pundits would tell you, credit spreads remain at elevated levels. In fact, on an inflation adjusted basis, rates are at the highest levels since the early 1980s. 

Why aren’t banks lending as much? Lack of confidence in the economy along with enormous embedded losses in their current book of loans. Those losses are real and will be rising. The elusiveness of bank credit is highlighted in a McClatchy article, Businesses Struggle as Bank Loans Remain Elusive, in the Newsworthy section of Sense on Cents.  

Thus, if a drop in Libor is not a reflection of improved credit conditions, what does it mean?

In my opinion, it is a precursor to a drop in the value of the dollar. Why?

Very simply, too many greenbacks floating around.  A decline in the value of the dollar is inflationary. Both core rates of producer prices and consumer prices reported this week were higher than expected. I’ll be watching.

Maybe a drop in Libor isn’t such a great development after all.

LD

  • Larry –

    I noticed something interesting looking at currency charts. The dollar started falling at almost the exact same time the stock market started this rally – around May 6 or 7. The dollar had a huge rally up until almost the exact point of the stock market bottom, and the dollar has been falling for the last two months, just as the stock market has (until this week) been rising over that same time period. Is that a coincidence or not? If not, what would you guess are the reasons for that?

    Matt

    • Sorry – I meant March 6 or 7, not May. Exactly when the stock market hit its bottom – March 6 or 7 is when the dollar peaked and the dollar has been down ever since.

  • The dollar has been a safe haven during times of crisis. As the markets rallied, and risk premiums across classes (stocks, bonds, emerging markets) came in the money left the dollar.

  • Pingback: London Calling: Libor Revisited and the Greenback()






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