April 24, 2018//-Since the start of 2018, the London interbank offered rate (or Libor) — the interest-rate benchmark for trillions of dollars of bonds, loans, mortgages and other financial contracts — has jumped to its highest levels since the financial crisis.
Typically, a spike in Libor would be cause for alarm since it would indicate that banks are struggling to meet their short-term borrowing needs. But in this case, Libor’s spike can be traced back to a confluence of idiosyncratic factors stemming, in part, from the US tax law. Richard Chambers, Goldman Sachs’ global head of Short Macro Trading, explains.
Richard, how significant is the rise in Libor and what’s driving it?
Richard Chambers: Since November 2017, the difference between Libor and the Federal Funds Effective-based Overnight Indexed Swap (OIS) rate — a key measure of credit risk for banks to borrow US dollars for three months — has widened to about 60 basis points from 15 bps.
That’s certainly an outsized move compared with historical levels, and can be attributed to a supply-and-demand shock in the short-term commercial paper (CP) markets. On the supply side, the US government has issued about $300 billion in Treasury bills in the first quarter to fund its fiscal initiatives. The surge in supply is pushing up borrowing costs across investment grade securities, especially on those with shorter maturities.
We’re also seeing the ramifications of the recently passed US tax law, which creates an incentive for multinational corporations to repatriate overseas cash. For years, these companies had parked their offshore cash balances in US dollars in money market fund securities, credit, repurchase agreements, Treasuries and, in particular, CP from European or Japanese banks.
But given uncertainty over repatriation, many of these companies have stopped buying — and, in some cases, started selling — these instruments as they look to determine how much to invest in share buybacks, dividends or capital expenditures. As a result, the fall in demand is translating into higher borrowing costs, as well as higher Libor rates.
There’s also a provision in the tax law known as Base-Erosion and Anti-abuse Tax, or BEAT, that is spurring a pickup in short-term investment-grade (IG) debt — which is one of the biggest barometers to setting 3-month Libor.
Prior to this year, non-US banks would often make short-term loans to their US affiliates for their funding needs as those loans were tax deductible. Under BEAT, the tax deductibility of those payments is now eliminated.
As a result, the US subsidiaries are turning to the short-term credit markets to raise money — another factor that is pushing up Libor. By our estimates, we’ve seen companies issue an additional $100 billion of short-term CP issuance in the first quarter, of which roughly $30 billion has been raised from offshore financial names.
How sustainable is Libor at these higher levels?
RC: We are pricing in some level of normalization and expect Libor to fall by least 25 basis points by year end. As companies pay their first tranche of taxes this month, many will start to get more clarity on how much money to put into other areas of investment.
Once the treasurers of companies, especially at the large technology companies that tend to hold a lot of cash overseas, get a better understanding of how to change their capital structure, they will come back to reinvest at the front-end of the credit markets.
The market is also pricing in retail inflow into prime funds at these attractive levels. However, we think — especially with the Fed continuing to drain liquidity — this normalization is overdone.
But isn’t Libor itself going away?
RC: The recent volatility of Libor certainly highlights the need for an alternative risk-free rate given its attachment to relatively lower volume markets like Bank Commercial Paper. UK authorities, as well as the Fed’s Alternative Reference Rates Committee, have targeted a 2021 date to replace Libor with the Secured Overnight Financing Rate, or SOFR, as newly published by the Federal Reserve Bank of New York.
But as my colleague, Nikhil Choraria has noted, the process of re-pegging Libor to alternative risk-free rates will take time as liquidity increases to enough of a level to support the volumes that currently transact in the Libor futures and derivatives market.
Goldman Sachs
