Yellen, LIBOR, Markets
David R Kotok
Cumberland, August 30, 2016
“Fed Chair Yellen and VC Fischer roil markets on rate hike comments” is the headline at Action Economics Weekly.
“If you look at the decision rule in footnote 8 in Yellen’s speech (August 26th), with 2% being the inflation target and the long-run real funds rate target being 1% above the inflation target, the long run Fed Funds rate would be 3%. Thus, the Fed would be expected to stop raising the rate at or not much above 3% unless inflation is greatly above 2%. But if the Fed raises the inflation target to 3% – as some suggest – that would put the ending funds rate at 4% or so! A 4% rather than 3% funds rate long term level would have enormous implications for the markets.” Source: Joel Naroff’s note following the Yellen speech.
“Money market funds have reduced their holdings of bank debt and shortened maturities of this paper [commercial paper of banks and CDs]. This has pressured LIBOR higher and LOIS wider.” (LOIS is the spread between LIBOR and the overnight indexed swap [OIS] interest rate.) Source: Joe Abate, Barclays, Money Markets Monthly Update, August 2016.
“We have entered the tighter credit phase of this cycle.” Source: John Silvia, Chief Economist, Wells Fargo, Interest Rate Weekly, August 24, 2016 (PDF).
Here at Cumberland we want to get into the weeds of post-Yellen-speech pricing. We will use live prices after the speech and live calculations of forward rates. For those readers who find the following too technical, in summary we are suggesting headwinds for markets. But in case you want to wade through the numbers below, these details may help you determine how to trim the sails. All prices and yields are sourced from our Bloomberg Terminal. We will round for convenience and ignore compounding and transaction costs.
Post-speech, the 3-month T-bill yielded 0.30%, the 6-month yielded 0.46%, and the 1-year yielded 0.60%. So a simple forward rate calculation determines that the market-based pricing estimate of the 3-month T-bill, three months from now, is 0.62%. (For a forward rate computation, take the difference between the later date rate and the shorter date rate and add that difference to the later date rate. That provides the market-based price estimate of what the second period rate will be in order to break even. The forward rate is the rate in the second period – here it is three months – at which an investor is indifferent to either rolling two 3-month periods or buying one 6-month period. So in this example, 30 for three months and 62 for three months ends up with the same amount as 46 for six months).
Similarly, to estimate the longer forward rate we take the 6-month T-bill at 0.46% and the 1-year at 0.60%. Thus the market, post-Yellen, priced the yield on the 6-month T-bill six months from now at 0.74%.
Many interpreted this as a mild market response. Sure, rates move higher, but not that much higher.
Let’s do the same exercise with LIBOR. Remember that LIBOR reflects changes in the structure of money market funds, and it reflects interest rates in the non-T-bill realm. LIBOR represents hundreds of trillions of dollars in loans and financings that are not directly tied to riskless T-bill interest rates. LIBOR is a real-world commercial, institutional, and personal financial reference.
Yellen never mentioned LIBOR in her speech.
Following Yellen’s speech, 3-month LIBOR was 0.83%, 6-month LIBOR was 1.22%, and 1-year LIBOR was 1.53%. Let’s do the forward rates. Three-month LIBOR, three months from now, is estimated at 1.61%. Six-month LIBOR, six months from now, is estimated at 1.84%. One can extend and project that the LIBOR yield curve will climb to over 2% within a year.
Some detractors say that this is due only to the major shift underway in money market fund characteristics. Maybe. But note that the money market rule changes take effect in about six weeks. We have purposefully extended this forward rate analysis to beyond the mid-October rule change date in order to avoid that October time frame. Our view is that other things are happening, too.
Look at the forward rate spreads. The 3-month spread between LIBOR forward and T-bill forward is projected to be over 100 basis points. The 6-month spread half a year from now is projected to be over 110 basis points. Note that this is now bumping up against the estimates of a 118–120 basis point rate that would be charged to activate swap lines between central banks in multiple currencies if there were an emergency need for liquidity in dollars or elsewhere. Note that the GSE debt tied to 1-year LIBOR exceeds $100 billion. It will reset up over $1 billion at an annual rate. Note that all this is happening while the market is pricing about a 50–50 chance of a single Fed hike in December.
At Cumberland, we have raised cash in our US stock market ETF accounts.
Note that LIBOR forward rates had helpful forecast power on the US stock market through 2009. After that year, the forecast power diminished and this stock market leading indicator became unreliable. Why is unclear. Was it the changes in LIBOR during the period following the revelations of LIBOR manipulation? Was it something else? One consideration to think about is that the same period had other financial changes that caused money market funds to blend a more conservative mix of CP/CD with treasury bills. Now that is changing again with the division between two types of money market funds. We shall see if LIBOR forward rates can be reinstated as US stock market leading indicators.
We continue to shorten duration and position defensively in managed bond accounts.
After BREXIT we changed our duration model. The down-draft in interest rates worldwide, post-BREXIT, accelerated all our models from the lower rate forecasts for next year and the year after. It did so in just a few weeks. We think the long decline in interest rates that has occurred for 35 years is now essentially over. And we think that the central banks in the US and some other countries will begin to achieve some limited level of inflation. So the headwinds are now in our faces.
We discussed this issue at length in Montana at Camp Kotok West. About 30 of us gathered at a wonderful and graciously welcoming location, Hubbard’s Yellowstone Lodge. We highly recommend it and plan to return. Some may have heard the Bloomberg Radio coverage with Mike McKee or may read Katie Darden’s interviews at SNL.
Most of the conversations in Montana were under the Chatham House Rule, but the takeaway from the group is clear. There is growing concern. And there is professional recognition that markets are very complacent. (We also got in a little fly fishing in Montana. Here is proof of a friendly mama rainbow trout, 23 inches long, released after the photo was taken. She was out of the water only 15 seconds. The rod was a 4 wt., 10 ft. Orvis Helios-2, and the fly was a red San Juan worm).
Lastly, Joe Abate of Barclays had an excellent summary of central bank swap lines and how they work with the BOJ. He wrote:
“The Fed maintains swap lines with several foreign central banks. These lines exist to provide dollar funding to non-US institutions against eligible, local currency denominated collateral. Banks apply to their local central bank, pledge local currency denominated collateral and receive dollars in return. The Fed and the central bank agree to exchange dollars for the currency and reverse the trade at up to 88 days in the future. The rate the Fed charges on these swaps is equal to OIS+50bp, where the OIS rate corresponds to the maturity of the swap. Both the Fed and the other central banks consider swaps line to be [an] emergency, back-stop facility that is not meant to be used as a supplement to existing private sector sources of dollar funding such as CP/CD and cross-currency basis markets. Currently, the BOJ and other central banks are only offering one-week dollar loans against local currency denominated collateral. Although the maximum maturity on these transactions is up to 3 months, the BOJ and the Fed have not currently agreed to provide 3-month dollar swaps. Thus the only swaps available from the BOJ are 7 days.” This topic was not mentioned in Governor Kuroda’s Jackson Hole speech.
Forward rates are telling us that LIBOR is going to bump against the emergency level. That implies that central banks will lengthen out the swap terms to avoid a liquidity crisis. Investors may choose to be sanguine about these changes. They do so at their own risk.
David R Kotok
Chairman & Chief Investment Officer