Why rising short-term borrowing costs are a constraint not a crisis
The recent jump in Libor borrowing rates has garnered some attention given the role spiking Libor rates played as an early warning indicator of the global financial crisis (GFC) and the importance of Libor as a benchmark for business and consumer borrowing. We explore the drivers of the recent rise in Libor and conclude it is not sending a signal of deteriorating credit quality like it did in 2007. Rather, increasing short-term borrowing costs reflect the impact of rising federal deficits and some special factors related to the recently passed Tax Cuts and Jobs Act. The prospect for further widening of federal deficits and an ongoing tightening in liquidity from the reduction of the Fed’s balance sheet suggests that short-term borrowing rates may remain elevated relative to the Fed’s policy rates for some time. This is what tighter monetary policy and some degree of crowding out of deficit-financed fiscal deficits looks like on the ground; some businesses and consumers will pay more to borrow.[1]
What is Libor and why is it important?
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate, which means it is used as the prevailing interest rate in a variety of loans and contracts. Libor is calculated daily in five currencies (US dollar, Euro, Yen, UK pound, and Swiss Franc) and for seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. Libor is currently calculated each day by Intercontinental Exchange (ICE), a private company supervised by government regulators that asks 20 participating banks at what interest rate they could borrow funds from another bank. The Libor benchmark rate is calculated as a trimmed mean of the middle 50% of responses. Figure 1 shows that as of 2016 Libor was referenced in nearly 200 trillion dollars of derivative contracts, corporate loans, floating-rate mortgages, floating rate notes (FRNs), and securitized products. The vast majority of financial contracts linked to Libor are actively traded interest rate and currency derivative contracts; however, Libor is also still the standard benchmark in a great deal of business and consumer lending.
Figure 1: Estimates US Dollar Libor Footprint by Asset Class (Trillions, 2016)
What did Libor spreads signal in the Global Financial Crisis?
Libor captures the cost of borrowing at short maturities. We will focus on 3-month Libor since it is by far the most commonly used term in business and consumer borrowing. The cost of borrowing is influenced by current and expected Fed policy on short-term rates, the credit risk of borrowers, and other factors that influence the demand and supply of cash in the financing system. To capture the impact of current and expected Fed policy on interest rates we will use the Overnight Indexed Swap (OIS) rate, which comes from a deep and liquid market of interest rate swap contracts that are tied to the federal funds rate set by the Fed, and therefore isolates the impact of Fed policy on rates.
Figure 2 shows that the spread of 3-month Libor to OIS served as an early warning signal of the Global Financial Crisis (GFC). Prior to August 2017 the Libor spread moved in a very narrow range below 10 basis points reflecting the fact that banks were generally considered to be very high credit quality institutions. Indeed, the development of Libor as a benchmark for indexing the borrowing rates for businesses and households rested on the proposition that Libor was close to a risk-free interest rate capturing the cost of bank funding. In late summer of 2017 banks were starting to doubt each other’s credit quality owing to the rising risk coming from rapidly rising delinquencies in mortgage securities and the rising interest rates they charged for lending. Libor spreads widened five months before the official start of the recession in December 2007 (shown by the grey shaded area in the chart) and a year before the full onset of the financial crisis. Libor spreads averaged around 75 basis points until the bankruptcy of Lehman Brothers when the Libor spread soared to 350 basis points, which understates the severity of the situation since interbank lending virtually dried up.
Figure 2: The Libor Spread Served as an Early Warning Signal of Deteriorating Credit Quality
Prior to the GFC, banks actively borrowed and lent to each other daily to finance their operations, and Libor captured that baseline cost of funding. These loans were not secured by any collateral, reflecting the short terms of the loans and the high credit quality of the institutions. The GFC occurred because banks took excessive and ultimately unprofitable risks, which shook the foundation of trust in their nearly risk-free status. Regulators around the world have taken steps to make sure banks are better capitalized and more closely supervised, but also to reduce their reliance on short-term, unsecured financing.
The GFC exposed the shortcomings of Libor as a reference rate, not only because of the riskiness of the banks and their funding model, but because Libor was found to be subject to manipulation. The US Commodities Futures Trading Commission (CFTC) worked with regulators in the UK to investigate abuses and ultimately fined nine institutions a total of $2.8bn. Some bank employees went to jail. A number of steps have been taken to ensure the integrity of Libor, but new bank regulations have made unsecured lending costlier for banks, leading to a reduction in the volume of lending covered by the benchmark.
The Financial Stability Oversight Council and Financial Stability Board called for the development of alternative interest rate benchmarks, and in 2014 the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC). The ARRC has identified the Secured Overnight Financing Rate (SOFR) as the appropriate replacement for Libor as a benchmark in financial contracts. The SOFR is a transactions-based rate based on secured lending; however, the transition is in the early stages with the ARRC starting to publish the SOFR this month. For now, Libor is still the standard benchmark for private lending.
What is Libor doing now and why?
Libor spreads have risen by as much as the Fed has raised interest rates over the last four months, leading to a double whammy for borrowers. The left side of Figure 3 shows Libor, OIS and the interest rate on Treasury bills, all at 3-month maturities and the right panel shows the spread of Libor and T bills to OIS. As the economic expansion has proceeded and the Fed has judged that the economy is closing in on full employment, they started to raise short-term interest rates after holding them close to zero for seven years. Since the US government is considered nearly risk free, there is no real credit spread and the interest rate on Treasury bills hugs quite closely to OIS. Libor always runs a bit above the risk-free rates reflecting the credit risk inherent in lending to private sector borrowers. Banks are once again considered to be high credit borrowers, so the Libor spread has generally averaged less than 20 basis points, but there have been some ebbs and flows in the spread, with a spike over the last four months taking it close to 60 basis points. There are competing hypotheses for why this is happening, with different ramifications for how long this will last, but they are all simple supply and demand stories with a net reduction in the supply of liquidity driving its cost higher.
Figure 3: Short-Term Rates are On the Rise, with a Double Whammy for Libor Borrowers
Hypothesis 1: Good Old Crowding Out
In a blog post earlier this year we wrote about a standard prediction of economic theory: that a significant portion of deficit-financed fiscal stimulus should be crowded out by higher interest rates, particularly in an economy close to full employment. It appears that a key culprit in driving up short-term interest rates above and beyond the increase implied by the expected path for Fed policy has been a deluge of issuance of Treasury bills in light of widening deficits from the Tax Cut and Jobs Act. Figure 4 illustrates that a step up in the issuance of Treasury Bills in recent months coincided with the spread between 3-month T-Bills and 3-month OIS moving from a range around -10 basis points to the most recent reading of 12 basis points. As the Treasury’s demand for cash pushes up their borrowing costs, banks and other private borrowers will have to pay a higher price to secure funding.
Figure 4: The Increased Demand for Cash from Rising Deficits Has Only Just Begun
It appears that roughly half of the rising Libor spread can be attributed to the increased demand for cash coming from widening fiscal deficits. The Treasury had made the decision to focus a lot of their borrowing at shorter maturities in part because there was a perception that there was significant demand for safe, short-term securities. The rapid move in the spread of T bills to OIS from negative to positive suggests that has quickly been satiated. This brings us to another standard tenet of economic theory, that there is no free lunch; whether the Treasury borrows at shorter or longer maturities, there is likely to be some consequent rise in interest rates and some degree of crowding out of fiscal stimulus. Since federal deficits have only begun a steady path of widening, this upward pressure is unlikely to abate any time soon.
Hypothesis 2: The Tax Cuts and Jobs Act is Disrupting the Funding System
Policy changes that impact the structure of the funding markets can lead to shifts in supply and demand that can disrupt funding costs. These disruptions can fade over time as market participants adjust to new policies. One example of this was in 2016 when reforms to the rules governing money market mutual funds lead about $1 trillion to migrate from funds that held private commercial paper to those that only invest in government securities. As shown in the right panel of Figure 3, this led to a widening in Libor spreads as private borrowers had to pay up to secure cash, while T bills enjoyed a greater premium. The Libor spike faded over a period of roughly six months.
The most recent disruption to funding markets comes from the Tax Cuts and Jobs Act, which featured an incentive for companies to repatriate overseas profits in order to pay a lower tax rate. Repatriation combined with other provisions of the law mean that companies are reducing the cash they had previously invested in commercial paper and other short-term private assets. Effectively the cash-rich tech and other companies that served as sources of funding in recent years because of tax avoidance are reducing their supply of cash, thus driving up borrowing costs. The financing system is flexible and resilient; it absorbed the changes wrought by money market reform and it is likely to restructure on the back of changes implied by the new tax law.
Figure 5: Rising Policy Rates Will Combine with a Declining Balance Sheet to Further Tighten Liquidity
Hypothesis 3: The Shrinking of the Federal Reserve’s Balance Sheet is Tightening Funding Conditions
Even as the Fed pushed longer-term borrowing rates lower by purchasing mortgage and Treasury securities in the recession and recovery, it actively worked on a plan that would allow them to control short-term rates in a system awash with the excess bank reserves created to finance their bond purchases. The concern was that they would need to soak up some of the excess liquidity in order to control short-term rates when the time came to tighten monetary policy. The Fed has been remarkably successful in their bid to maintain the federal funds rate in a narrow range, but they have been helped by a number of forces reducing liquidity in the system, including the two already discussed. The Fed’s plan to increase the pace of balance sheet reduction this year will continue to shrink liquidity in the system and maintain upward pressure on borrowing costs.
The left panel of Figure 5 shows the value of Treasury and Mortgage securities on the Fed’s balance sheet, along with the projected plan to reduce these holdings over the next several years. The green dotted line in the chart shows the value of excess reserves held by banks at the Federal Reserves; when the Fed bought securities, it paid for them by crediting banks with excess reserves that would then circulate in the system. Even before the Fed started reducing its balance sheet in Q4 of last year, excess reserves were declining. The right chart shows that part of the reduction in excess reserves was precisely the result of the Fed’s efforts to soak up liquidity in the system through its reverse repo facility with financial institutions that was put in place when they started raising short-term interest rates. The Fed’s facility never grew as much as expected, in part because of what money market guru Zoltan Pozsar at Credit Suisse refers to as rising demand for the Fed’s overnight liquidity services.[2] The Treasury and foreign central banks have started to maintain large deposits at the Fed instead of in the banking system as a result of provisions in Basel III the disincentivize banks from holding large, institutional deposits. Any increase in deposits by these entities naturally reduces excess reserves. The result is reduced liquidity for lending at banks and a reduction of more than $500bn in excess reserves in recent years before the Fed actively started to reduce its balance sheet. The left panel of Figure 5 highlights that ongoing reductions in the Fed’s balance sheet should continue to tighten funding conditions and maintain upward pressure on short-term interest rates.
It does not appear that the widening in Libor spreads is playing the same role as an early warning indicator of deteriorating credit quality in the banking system as it did in the financial crisis. Instead the sharp rise in Libor is a reflection of both some crowding out of fiscal stimulus, some special factors unique to the tax bill, and ongoing tightening in monetary policy. Figure 6 shows that some affected consumer and business borrowing rates have risen 1.0% in recent months, twice the increase in the fed funds rate. Both the rise and the uncertainty around where Libor will settle may also be contributing to rising volatility in some markets given the wide and huge amount of interest rates and currency derivative contracts affected. Some of the tax bill effects may fade, but it is unlikely funding conditions will ease from here in light of ongoing federal debt issuance and monetary tightening. This is what crowding out and monetary tightening look like in practice and there is likely to be some dampening effect on interest sensitive economic activity.
Figure 6: Tighter Financing Conditions Contribute to Higher Borrowing Costs and Volatility
[1] I want to thank Lundy Wright, Tim High, Peter Jepsen and a few other thoughtful market participants for helping educate me on the complexities of this issue. I firmly believe that the wisdom of people that take risk every day in financial markets is essential to informing a bigger picture understanding of the economic ramifications.
[2] Pozsar publishes a series called Global Money Notes that dives into the intricate plumbing of money markets.