Diary of a Financier

LIBOR Continues to Grope All-Time Lows?!

In Capital Markets on Tue 24 May 2011 at 23:21
  • LIBOR still setting all-time lows, day after day.
  • With the witchhunt for counterparty lemons to ensue per the Euro crisis, LIBOR is mispricing systemic risk.
  • Since so many loans price off LIBOR, artificially low LIBOR could have a harsh ripple effect upon creditors & investors in fixed or floating rate mechanisms.

This is quite a simple entry from me.  I’m looking across the LIBOR spectrum tonight, and I can’t help but notice that all LIBOR terms (overnight through 12 month) are still continuing lower, setting all-time lows, day after day, since Christmas 2010:

LIBOR overnight (2009-present)

LIBOR 12 month (2009-pres)

LIBOR 12 month (1991-present)

Now, to justify low LIBOR rates, look no further than all of BBA banks’ liquidity (excess reserves) compiled since the start of QE2.  Yet, LIBOR is a risk gauge, and I can’t fathom how realized risk can be as low as LIBOR implies, given the forgone conclusion of EU periphery restructurings.  There are risks that we know–and more importantly those that we don’t–associated with Europe.  I can accept that the market has adequately discounted the risk of a Euro fringe collapse. But, beyond firms reporting direct exposure to the sovereign bonds, unfounded firms are hiding off-balance-sheet exposure, OTC derivative exposure, etc.  We know who holds the bag for European PIIGS haircuts…

Bank Holdings of PIIGS Sovereign Debt (May 2011)

…but now begins the witchhunt for counterparty lemons.  Therein lies uncertainty manifest, the systemic devil, for whom risk should be priced more appropriately.

The problem is more entangled than this, for much of the world’s interest rate mechanisms price off of LIBOR: student loans, auto loans, composite rates (i.e. margin rates), bank loans, and mortgages.  I’m more worried about the mispricing of the risk embedded in these loans than that in interbank loans.  For the fixed rate loans, there will be a point where the owner of the cashflows can’t hedge his rate exposure at a reasonable price, because everyone is piling into derivatives positions (swaps, etc.).  For the floating rates, you have the same issue with debtors that you had with mortgagees who were sucked in by teaser rates.

On April 26, I made a great call for interest rate flatteners:

…the curve-flattening trade is a huge winner over the next two quarters.  Rising short-term rates is vogue on the Street right now.  That’s not a novel revelation.  But piggybacking on that notion, consensus calls for the entire yield curve rising in a parallel, outward shift.  Mr. Gundlatch & I are lonely contrarians here.  Not only is the yield curve historically steep, but using the closing months of QE1 as a guide, I expect short-term rates to start rising within an earshot of QE2′s end, with longer-rates falling even sooner.

With the recent rise in the 3-month T-Bill (.IRX) from 0.005% to 0.05 vs the drop in the 10-year (.TNX) drop from 3.27% to 3.12, we’ve experienced a big 20bps in flattening between the two.  I added duration to my bond allocation just in time to catch this rally, but I’m also sitting with some short paper, including  a few high yield names (holding-to-maturity) and floating rate bank loans.  So, I need to make a decision about how far/fast the front end will rise, particularly as it pertains to my bank loans.

I harp on VIX as the “dumb money,” a misinterpreted “leading indicator” that’s really a coincident proxy for volatility.  I’m quite happy to have benefited [marginally so far] for buying volatility down around its lows, but VIX going from 14 to 18 doesn’t mean the marketplace recognizes the risk in the system… not with LIBOR down here.

–Romeo

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