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Love it or hate it, Libor's rise matters for trillions of debt

[NEW YORK] While the rest of the bond market takes the Federal Reserve's latest interest-rate increase in stride, Libor is surging. And that still matters.

The steady march higher in the London interbank offered rate shows the US central bank's tightening cycle does have consequences even as measures of overall financial conditions show they've eased as the Fed hiked rates this year. Libor serves as the basis for trillions of dollars in loans and floating-rate securities despite regulatory efforts to replace it following a price-fixing scandal.

"Libor represents a key benchmark proxy for short-term rates still to this day," said Jerome Schneider, head of the short-term and funding desk at Pacific Investment Management Co.

"Investors and market participants realise that the Fed is finally serious about normalising monetary policy and their balance sheet and that short-term rates have to go up well above zero."

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Three-month dollar Libor reached 1.58849 per cent before Wednesday's Fed rate increase, the highest level since the midst of the global financial crisis in December 2008.

For Kerrie Debbs, partner and certified financial planner at Pennington, New Jersey-based Main Street Financial Solutions LLC, the rise is already having an effect. Clients buying homes are shying away from adjustable mortgages given risks of higher costs, she said.

Younger buyers "want more certainty now through doing a 15- or 30-year fixed mortgages," Ms Debbs said. "Or they are less likely to put their entire big mortgage on the adjustable side." The key indices used for US adjustable-rate mortgages are the one-year Treasury bill rate, Libor and the San Francisco Fed's 11th District Cost of Funds index (COFI), according to Bankrate.com.

The COFI index is at 0.737 per cent, up from 0.583 per cent in March, while one-year bill rates have risen to 1.66 per cent from 0.76 per cent in January.

About US$350 trillion of financial products and loans are linked to Libor, with a large chunk hinged to the dollar-based benchmark.

"It is the rate of change on an extraordinary amount of debt that is priced off Libor," said Peter Boockvar, chief market analyst at Lindsey Group. "A lot of people have floating-rate debt that repriced to Libor plus some spread and that cost of capital continues to rise."

The effects are filtering through even as surging stocks and narrowing credit spreads have caused an easing in the broad-based financial conditions the Fed uses to help guide policy.

New York Fed President William Dudley has cited that softening financial conditions is one reason why more rate increases were needed. So don't expect the Fed to help slow Libor's rise.

Fed officials on Wednesday raised their forecast for economic growth in 2018, even as they stuck with a projection for three hikes in the coming year.

And the velocity of Libor's surge actually has a better chance of picking up if President Donald Trump and congressional leaders achieve their centerpiece tax-overhaul legislation.

Goldman Sachs economists say completion of the tax bill will lift growth over coming years, buoy inflation and lower the unemployment rate. The combined affects would warrant Fed officials to add two 0.25 per cent rate hikes to what they now signal, Goldman predicts.

Goldman is one of a few Wall Street firms forecasting four Fed rate increases next year, compared to the three central bank officials now signal.

"The increases in short-rates for anything tied to Libor will have costs go up, and that could potentially have an impact on those that are more stressed borrowers," said Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors, which manages US$2.7 trillion. For now, however, "the impact on consumers and business in terms of their cost of capital and the cost of their mortgages is still fairly well contained."

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