Prior Week Summary
As the implementation date for money market reform draws closer, LIBOR settings continue to increase at a steady pace. On an absolute basis, 3-Month LIBOR has now increased nearly 17 basis points since the beginning of the quarter, bringing the index to its highest level since 2009. The higher LIBOR settings have caused the LIBOR/OIS basis, often seen as a measure of stress in the interbank lending markets, to widen by approximately 13 basis points over the same time frame. As of this writing, the LIBOR/OIS basis stands at its widest levels since the height of the European sovereign debt crisis in 2011-2012 (bottom chart).
As the October implementation date approaches, continued upward pressure on LIBOR could cause the spread to widen further, as the short-term funding markets work to find a market clearing price. This dynamic is also likely to be compounded by the typical year-end funding pressures that will come into play just as the dust is settling in mid-October.
While widening spreads in the money markets are typically seen as a potential harbinger of broader financial market stress, the current widening event is largely perceived to be a short-term dislocation relating to looming money market fund rule changes. Broadly speaking, the coming rule change will move prime money market funds to a floating rate NAV, as opposed to a fixed rate of $1.00 per share. The impending change has caused material changes in the relative AUM of prime/government funds, which in turn has caused portfolio managers of prime funds to shorten the duration of their holdings to prepare for potential worst case scenarios for fund redemptions. The LIBOR panel banks who have exposure to these funds have, in the aggregate, accepted higher funding levels (and spreads), for increasingly shorter durations to maintain liability balances.
It is important to note that, at this point, while spreads in the interbank funding markets are somewhat elevated when compared to the very recent past, they are still low in a longer term historical context. In 2011-12 the concern that drove LIBOR higher relative to the government curve related to an increased perceived risk of euro-zone financial contagion. In that episode, LIBOR rose for a time before normalizing, as the market came to realize that central banks around the world would institute swap lines and other policy accommodations to ease the stress in money markets. Those mechanisms still exist and could be used to facilitate proper market functioning if the dislocation were to accelerate.
The Look Forward
The highlight of this relatively busy week will be the release of the minutes of the July Fed meeting on Wednesday as well as updates on CPI, Industrial production, and the labor markets.