<p>The USD London Interbank Offered Rate (LIBOR) has risen to 2.31%, at decade highs. The dislocation in the LIBOR rates could be technical in nature, similar to the money market reform scenario in 2016. Or it may be a percursor of deteriorating monetary conditions akin to the 2008 financial crisis. We discussed both scenarios below.</p><p><b><span style="text-decoration: underline;">1. </span></b><b><span style="text-decoration: underline;">Technical justification for</span></b><b><span style="text-decoration: underline;"> the </span></b><b><span style="text-decoration: underline;">rise in </span></b><b><span style="text-decoration: underline;">LIBOR</span></b></p><p>The 3-months LIBOR has doubled to 2.31% within a year. Similarly, the spread between the 3-month LIBOR and 3-month Overnight Indexed Swap rate (LIBOR-OIS) has widened to 59 bps. Both are near their decade highs.</p><p>The previous spike in rates was in 2016. LIBOR started climbing as a result of change in US money market fund regulation. US money market funds that invest outside of US government papers had to switch to a floating NAV. The regulatory change drive monies out of these funds and trigger the rise in LIBOR. However, the distress was only temporary as the LIBOR-OIS rate spike to a high of 43bps in September 2016 before retracing to below 10bps in the middle of 2017.</p><p>This time, the rise of LIIBOR could be attributed to US tax reform. US companies holding offshore cash are reducing the duration of holdings to repatriate money back to the US. Instead of issuing bonds to fund share buyback, these companies are reducing these bond issuance. This has led to the upward climb in LIBOR as these corporates sell the front-end of the curve.</p><p><b><span style="text-decoration: underline;">2. Canary in the coal mine</span></b></p><p>The rise in LIBOR could have another implication. It could signal deteriorating monetary conditions. The current gap between LIBOR and US 5-year yield is around 25 bps (assuming 5-year yield of 2.56%). This gap could turn negative in less than a month assuming a steady climb in LIBOR over the US 5-year yield, implying a yield curve inversion. This indicates funding stress as investors are unwilling to lend money in the near term.</p><p>Back in 2008, there were excessive leverage in the economy especially among companies and consumers. So, the up swing in LIBOR highlights the funding stress in the banking system. This time round, rising rates could hurt the highly indebted companies,especially those that are non investment grade. It is estimated by UBS that there are more than $2 trillion in junk-rated loans. These companies have less favourable access to the capital markets and will be hurt by the rise in LIBOR.</p><p>So far, the effects from the rise in LIBOR are well contained as economic growth remain strong. However, the unabated rise of LIBOR could spill over to a market correction if funding stress hit the economy. The LIBOR do not lie. The truth could hurt.</p><p><strong>Edmund Chan, CFA</strong></p>