Most of the 17-basis-point increase in USD 3-month LIBOR levels since the end of June should be attributed to regulatory considerations and not to the Fed monetary policy, believe analysts at Bank of America Merrill Lynch. Mark Cabana and colleagues said in their August 24 research piece titled “LIBOR into and out of reform” that they believe LIBOR spreads should narrow after the October reform date and contribute to near-term FRA-OIS curve inversion.
LIBOR spread could widen further in September
As outlined by ValueWalk, a new SEC rule will come into play in October affecting money market funds and liquidity across the financial sphere. The new rule stipulates that prime and municipal money market funds will have to float their NAVs.
Oppenheimer Funds’ chief investment officer pointed out that as a result of prime money market funds being moved to government money market funds, there is a big mismatch between the supply of the dollar funds and the large demand for these funds from international banks. He believes these developments led to an increase in LIBOR rates.
Echoing a similar view, Cabana and colleagues at BAML point out that decomposition of 3-month LIBOR highlights that the recent rise is not due to the Fed. They argue that much of the recent rise in USD LIBOR settings has been due to regulatory changes.
The BAML analysts highlight that part of 3-month LIBOR can be explained by Federal Reserve policy expectations decreasing from 63% at the beginning of the year to 52% today. The analysts believe the balance of the rise in LIBOR can be attributed to upcoming money market mutual fund reforms as opposed to increased credit concerns:
The BAML analysts argue that while LIBOR appears to have reached a temporary equilibrium, they believe spreads could widen further as we move into September amidst large prime fund CP and CD maturities and as 1-month LIBOR crosses over the reform implementation date. However, the analysts believe any near-term LIBOR spread widening will be slower as opposed to July.
LIBOR spread could narrow following money market reform
Cabana and colleagues argue that LIBOR spreads could also widen due to an acceleration of prime fund outflows. The analysts anticipate roughly $200 billion to 300 billion in outflows over the course of September and October, which would signify the most rapid prime fund withdrawal since the financial crisis.
Tthe BAML analysts anticipate that LIBOR-related spreads will partially retrace their recent widening but set at a structurally higher level. The analysts argue that the modest retracement in LIBOR spreads could be aided by various factors such as a reduction in the amount of unsecured short-term bank funding and a rebound in prime fund WAMs. They believe each of these factors should aid the inversion of the FRA-OIS term structure in the near term. The BAML analysts believe this inversion could become more pronounced depending on the extent of prime fund inflows after reform.