Musing on the implications of a higher dollar LIBOR

As many readers may have observed recently, US dollar LIBOR has been ticking up noticeably over the last week or two.  3 month LIBOR is now 72 bps, the highest it has been since mid-2009.

On the face of it, this is something of an odd phenomenon; just yesterday, for example, Macro Man was musing about how little was priced into expectations for FOMC tightening, yet here we have a key short term rate ripping higher.  The contrast with this month's activity in repo rates is also notable...

Source: DTCC

FRA/OIS has widened sharply, a move that has not been reflected in other currencies, as the chart below amply demonstrates.

What's going on here?  The answer, quite simply, is money market fund regulation in the US.  This has been well-flagged amongst fixed income investors but is perhaps less well known in the equity space,  Essentially, on October 14 prime money funds will see their statutory maximum weighted average maturity fall from 90 to 60 days, will be forced to institute floating NAVs to reflect the actual underlying value of their turds assets, and will have the ability to impose a temporary gate should things go badly awry.

The upshot is that prime fund assets have fallen by nearly $500 billion over the last year or so, with government-only assets rising by an equivalent amount.  This represents a significant decline in demand for commercial paper and other short term private sector instruments which should, all else being equal, push those yields higher.  Why did LIBOR start ticking higher last week?   Well, that was when the 3 month maturity date fell after the October 14 reform trigger date.  You can read more about these issues here and here.

While this is interesting in its own right, Macro Man is more interested in thinking about possible implications of a quasi-permanent rise in LIBOR:

* A stronger dollar.  In a world of ZIRP and NIRP, every little bit of yield helps.   Increasing the dollar's yield premium over the rest of the G4 should give it a little boost.   Beyond that, however, there's the question of flows.  The LIBOR panel is made up of mostly foreign banks, many of which have made a practice of borrowing USD by selling commercial paper to money funds.  If the demand is no longer there and/or the rates are pushed higher, at some point it may just be easier to buy USD in the FX market than to borrow it.  We have seen this movie before where cross currency basis heats up; it seems likely to do so again.

* Continued FRA/OIS widening?  Consensus seems to be that although spot FRA/OIS has widened quite a bit, it could eventually resolve up to 45 bps or so.  From Macro Man's perspective, that seems fairly punchy; at some point, it will become attractive to take the credit risk in prime funds if they are offering, say, double the yield of govvy funds.   If we do end up seeing such a swing in a few months, that should push FRA/OIS back down, though not to levels prevailing before the regulation started to bite.

* Weaker gold/commodities?  Obviously in the bigger picture gold has performed strongly, thanks to the extremely low level of real interest rates around the world.   However, if real short cash rates in the US rise and the dollar performs well, this could represent a further headwind for metals, particularly given the flows into the spaced over the last six months.

* Whither credit spreads?  If we observe a permanent widening in short term credit spreads, should that have an impact elsewhere?  To be sure, it's possible for the credit curve to flatten, but in extremis if you could get a yield pickup in a high quality prime money fund similar to what you could get from investing in IG, wouldn't you do that?  (This is not to say that these spreads will ever come close to the same level.)  At some level, however, ructions at the front end of the credit curve should begin to impact the rest of the credit market.  If Macro Man is right about a natural lid to how far FRA/OIS can go, then it may not be an issue, but still bears watching.

*Higher vol?   Yeah right.

Readers, particularly those with intimate knowledge of the issue, are invited to weigh in with their own views.