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We Called This Flashing Danger Signal Back in October – Here's What's Next

While all eyes are on interest rates in the Treasury market, an even more important global interest rate recently breached a key level for the first time since the financial crisis:  the London Interbank Offered Rate (LIBOR).  On Dec. 29, 2016, LIBOR hit 1% for the first time in seven-and-a-half years.

I wrote back in October of last year, when LIBOR had reached 80 basis points, that a move up past 1% could spell trouble for the credit markets. We have now reached that point and are starting to see signs of strain on which we need to keep a close eye.

SMI-Graph

LIBOR is an uncannily accurate thermometer that measures the banking industry's health: In normal times, low rates mean banks are doing well, while higher rates indicate reduced public confidence and a struggling industry. Right now, we are not living in normal times and it is more difficult than in the past to determine how to read market signals such as LIBOR. Nonetheless, LIBOR remains an incredibly important global benchmark, and its rise will meaningfully increase borrowing costs across the global economy.

Corporate credit quality is deteriorating not only among junk borrowers, but also among investment-grade companies that borrowed tens of billions of dollars to pay dividends and buy back overvalued shares. While the inability to earn a decent return on capital in fixed-income markets poses enormous challenges for investors, outright losses are far more dangerous. And that is what they are facing if rates rise even modestly.

Here's what to expect now that LIBOR has breached the 1% mark – and how you can profit.

What Rising LIBOR Means for You – and How to Profit

You may have heard about LIBOR because it was widely manipulated by bankers in London and New York before and during the financial crisis.  A number of these individuals were prosecuted, and several large banks paid huge fines to atone for their sins.

In order to understand LIBOR's importance to the global financial system, it is important to understand the scale of its usage around the world. After widespread LIBOR manipulation was discovered, a new regime was put in place that seems to be working reasonably well.  There are currently 38 clearing members in LIBOR in five major currencies (USD, EUR, GBP, JPY, and CHF).  These firms post rates for seven different LIBOR maturities in these currencies.  The most widely used maturity is three-month USD LIBOR.  There are tens of trillions of dollars of debt and derivative contracts priced off this benchmark.

Banks use LIBOR to price short-term loans of one, three, and six months to each other.  U.S. investors are familiar with LIBOR in the leveraged bank loan market where U.S. corporations borrow hundreds of billions of dollars to finance everything from leveraged buyouts to stock repurchases to capital spending.  This market collapsed during the financial crisis due to knee-jerk moves by credit agencies Moody's and S&P to change the rules governing collateralized loan obligations, which are among the largest buyers of leveraged loans.  The market recovered and leveraged loans play a key role in the leveraged finance markets again today.

After the financial crisis, LIBOR dropped from over 2% to as low as 20 basis points.  This forced the leveraged loan market to adjust by adopting "LIBOR floors" on loans, which meant that loans continued to be priced off LIBOR, but LIBOR was assumed to be a minimum of 1% or higher, and the actual (and much lower) market rate was ignored.  This allowed bank loans to carry sufficiently high interest rates to attract buyers. There are approximately 1,200 loans in the S&P/LSTA Leveraged Loan 100 Index, and 90% of them have LIBOR floors.  Of those with LIBOR floors, 67% of the floors are set at 1%.

As LIBOR rises above 1%, coupons on many bank loans will increase, rendering this asset class more attractive to investors.  Investors seeking to benefit from this can buy PowerShares Senior Loan Portfolio ETF (NYSE Arca: BKLN), which invests in the 100 largest bank loans.  Among other things, BKLN is a good cash alternative that should earn several hundred basis points more than money market funds.

On a larger scale, however, LIBOR's rise has troubling, far-reaching implications.

LIBOR's Widening Spread Points to a Troubling Future

As a short-term interest rate that is reset daily and used on tens of trillions of dollars of live transactions, LIBOR is a key measure of market risk.  LIBOR is quoted daily in two ways.

  • The first is spot pricing reported by the member banks.  The spot price is the interest rates banks charge each other for unsecured loans.
  • The second is through Forward Rate Agreements (FRA).  These are financial contracts between two parties trying to protect themselves from future interest rate moves.  Generally, the buyer of an FRA seeks to lock in a fixed-interest rate in exchange for a payment to the seller.

Recently, David Kotok of Cumberland Advisors pointed to a troubling widening in the spread between the spot price and the FRA contract price of three-month USD LIBOR that may point to rising risk in the global financial markets.  This spread has widened steadily over the last three years from 17 basis points (0.172%) at the end of 2014 to 32 basis points (0.316%) at the end of 2015 to 60 basis points (0.6042%) at the end of 2016.

This widening spread means several things: first, risk premia were rising the market long before Donald Trump's election (starting back in 2014); and second, global demand for U.S. dollars is rising while the supply has held steady.

This phenomenon is receiving little attention in the financial media or on Wall Street and is not yet at levels that suggest systemic stress. But if it continues, it could cause problems.  A U.S. dollar shortage could cause the currency to spike in value, which would hurt U.S. corporate earnings and cause other market disruptions.  Mr. Kotok's firm does excellent research and investors should keep a close eye on LIBOR in the months ahead for signs of potential systemic stress.  Remember, we are in the midst of an epic bond bubble, and we have an extremely expensive stock market that is partying like it's 1999 on hopes and dreams that Trump will make America great again.  We can all hope for the best, but mundane things like LIBOR could throw a wrench into the works.

Sincerely,

Michael

The post We Called This Flashing Danger Signal Back In October – Here's What's Next appeared first on Sure Money.

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About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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