Up and Down Wall Street
Is the Market Doing Yellen’s Dirty Work?
Regulatory changes are boosting borrowing costs. How will that affect the September FOMC meeting?
By Randall W. Forsyth
Amid the never-ending chatter about Federal Reserve interest-rate increases, the money markets have stealthily enacted one on their own.
The London interbank offered rate, or Libor, has risen by roughly a quarter percentage point in recent weeks, and it has nothing to do with Brexit. Coming changes in regulations affecting money-market mutual funds have pushed up the rate, which is the benchmark for many loans for businesses, municipalities and regular folks.
How the rise in Libor, which is up to just under 0.8%, will figure into the calculations when the Federal Reserve deliberates over its monetary policy next month is an open question. While it ponders whether to hike its overnight federal funds rate target (currently 0.25%-0.50%) by another 25 basis points (a quarter percentage point), the private sector already is paying an additional 22 basis points more on many business and adjustable-rate mortgage loans based on Libor in the past six weeks.
This is an unintended consequence of money-market fund reform, which takes effect on Oct. 14. On that date, money funds will effectively be more like short-term bond funds with a variable net-asset value instead of the constant $1.00 a share NAV that was their hallmark since their introduction in the 1970s. After the Lehman Brothers bankruptcy in 2008, the Reserve Primary Fund, the original money fund, famously “broke the buck” as a result of its holdings of Lehman commercial paper.
The new rules won’t apply to so-called government money funds, which stick to short-term Treasury or U.S. agency obligations. The transaction account linked to your brokerage or mutual-fund account may have been shifted to a government money fund as a result of that pending change.
As Tuesday’s Wall Street Journal reports, municipalities are being forced to pay higher interest costs on their short-term borrowings. Money funds have been bracing for the rule change for a long time, but the effects have only become apparent recently in the short-term money market as the effective date has come into the maturity range of three-month paper.
Citigroup analysts Vikram Rai and Jack Muller write that efforts by money funds to build liquidity in anticipation of liquidations on the Oct. 14 effective date have created a “vicious feedback loop.”
Money-fund managers have shortened maturities, eschewing longer paper in money market, they write. That has pushed up three-month Libor and commercial-paper rates, but money-fund investors haven’t benefitted much while the funds’ portfolios have stuck with lower-yielding shorter paper.
The Citi analysts expect an additional rise of five-to-10 basis points by Oct. 14. By year end, they expect three-month Libor to be up to 1.05%-1.10%, up from 0.623% on June 24—its recent low just after the Brexit vote.
This sharp rise in borrowing costs could be considered a stealth tightening by the Fed. But according to a research note by Goldman Sachs economist Zach Pandl, the rise in Libor is being more than offset by other factors resulting in easier financial conditions for the overall economy.
Goldman estimates 15%-20% of household debt and 25%-30% of business debt is linked to Libor. And for the latter, Libor already is below the floor set in many loan agreements, so a rise in the market rate won’t affect those loans’ cost.
In calculating the firm’s Financial Conditions Index, Goldman takes into account other factors. These include credit-quality spreads in the bond market and the equity market, which are alternative sources of financing for corporations.
According to Goldman’s FCI, the rise in Libor increased the cost of financing by all of two basis points since mid-June. But the rally in the credit markets reduced its FCI by seven basis points since then while the equity rally has lowered the gauge by 24 basis points. All told, the net reduction in financing costs has been 29 basis points, by Goldman’s reckoning.
Which may be the case for the firm’s corporate customers but for small businesses and households, it’s a different story. They don’t have the option of bringing a multi-hundred-million-dollar bond or stock offering to market. For them, whether the rate increase came from the action of the money market or the Fed is immaterial.
How will the Federal Open Market Committee weigh these factors next month? Will the strength of the stock and credit markets, the jobs data showing full employment by conventional measures and service-sector inflation climbing combine to bring about the long-promised rate hike? Or will the rise in Libor be viewed as a stealth tightening that did the Fed’s dirty work?
That’s just one of the questions investors hope will be answered by Fed Chair Janet Yellen when she speaks to the annual Jackson Hole confab on Aug. 26. In the meantime, the markets seem to be off on summer holiday ahead of her eagerly awaited address.