When rising money market rates make the news, it usually implies extreme financial stress.
With investors still looking for which central bank will next inject liquidity into the market, that seems far-fetched. While the Bank of Japan may well — and should — cut rates this week, central banks may be changing tack. The Federal Reserve is threatening to raise rates; the European Central Bank has not added to its quantitative easing; Chinese reserves have seen renewed outflows and there are concerns over BoJ tapering. Some believe the BoJ and ECB QE is having no, or even a detrimental, impact on igniting reflation.
Meanwhile, money market rates and some indicators of market dislocation have reached levels not seen since 2009. It is time to think about what this means.
The striking rise in Libor — a benchmark interest rate — is a consequence not of monetary policy, but of regulatory changes governing the $2.7tn money markets.
Equity investors should not ignore the impact of changes to money markets. In September 2008, it was arguably the Reserve Fund, one of the then biggest money market funds, “breaking the buck” by failing to maintain its $1 NAV which sent the biggest shockwaves through the markets.
In 2010, new regulations meant to prevent a repeat of 2008 resulted in money market funds holding more short-term liquidity, which led to a shortage in dollar funding for European banks and then morphed into the European credit crisis. The latest changes are the next phase in these reforms.
The new money market rules, which require prime funds to mark to market and allow the imposition of gates and penalties for withdrawals, have caused an exodus to those funds that invest only in government debt. As a consequence, three-month dollar Libor has risen to 85 basis points from 65bp in June, and Libor futures imply a rate above 1 per cent for the whole of 2017. In effect, the tightening the Fed is considering has already happened.
It is unlikely rising money market rates will produce another banking crisis. Central banks understand the dollar funding relationship a lot better and their swap lines provide a backstop, although at a price.
The implications will again extend globally though.
For the BoJ, going deeper into negative interest rate territory may have little positive impact, but it may be forced to if only to curb the pace of the yen’s rise
Japanese banks are the largest borrowers in the dollar interbank market and their demand for dollars has driven yen currency swaps to their widest levels since 2011. One-month yen currency swaps are offering yields up to 1.95 per cent, increasing the attractiveness of the yen for sovereign wealth funds and other yield hunters. Put like that, the yen is not the lowest, but the highest yielding major currency in nominal terms and, in the G20, in real terms.
For the BoJ, going deeper into negative interest rate territory may have little positive impact, but it may be forced to if only to curb the pace of the yen’s rise. For Japan’s banks the rising costs of dollar funding is another potential source of margin erosion in an already negative domestic rate environment.
Rising Libor rates may also be exacerbating a sell-off in global bonds.
Our indicators show financial stress at its highest levels since 2012, but not at levels where it can be considered systemic. However, markets are implying that the changes are structural, unlikely to ease any time soon and Libor rates for 2017 remain close to the central bank swap backstop rate.
Yields offered by one-month yen currency swaps
The problem is not a lack of dollar funding, but where those funds are and whether they can be successfully intermediated to market participants who need them. The normal intermediaries are now restricted by regulation.
Equity investors have recently been buying cyclicals and value stocks and selling yield and defensives in the hope of growth.
Market bulls have pointed to the rally in bond yields and cyclical growth names as support for this. But if those moves are just an unravelling of crowded yield-hungry equity positions, made worse by a lack of additional bond buying by the ECB and BoJ, then by owning growth names, equity investors may find themselves in the wrong place when the real economic impact of higher rates is felt or the renminbi falls.
Investors would be wise not to ignore the pervasive impact of changes to money market regulations. Higher dollar Libor rates could argue for a stronger dollar against most currencies — the yen excepted — and higher equity and bond volatility argue for an increased allocation to cash, a shortening in duration and “bond refugee” stocks.
For investors, the TINA (There Is No Alternative) case for owning equities now faces a competitor — LARA (Libor As a Real Alternative). At least until investors can extract from policymakers fresh promises of the “liquidity put” they have come to rely on.
Mohammed Apabhai is head of Asia-Pacific trading strategy at Citigroup
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