Fixed income investors need to stay nimble
Charlotte Baenninger, Head of Fixed Income
One of the most notable features of the global fixed income market in 2018 thus far has been the sharp increase in USD Libor rates – the market interest rate at which banks lend dollars to each other in London over various short-term horizons. Libor rates – and the spread between Libor and market expectations of the Federal Funds rate – are therefore widely watched benchmarks and seen by many as a gauge of overall credit market conditions. The 60 basis point increase in USD Libor since the start of the year to levels last seen in the financial crisis in 2008 (See Exhibit 1) has therefore prompted much comment and consternation. The increase, however, has not been accompanied by equivalent increases in EUR Libor or GBP Libor. This suggests very strongly that the increase reflects specific technical factors in the US market rather than investor concerns about overall bank creditworthiness.
In our view, the increase in US Libor likely reflects a combination of factors. US tax reform has precipitated a repatriation of US dollars held overseas by US corporations. This overseas cash had become a significant source of funding for global markets. The owners of this cash are not simply leaving this money on deposit once repatriated. By employing some of this cash for M&A and capital expenditure, demand for commercial paper and other money market instruments from corporates is falling. All this comes at a time when the widening US budget deficit is being funded by increased US Treasury Bill issuance. Unsurprisingly given the volume of issuance, the US Treasury is having to compensate investors with higher yields. In turn, this puts upward pressure on money market rates by ‘crowding out’ commercial paper markets. Despite the increase in front-end rates, volatility in global fixed income markets has remained relatively subdued. As the US Federal Reserve continues on its path of monetary policy normalization at a time when the issuance schedule for US treasuries is significant, we suspect volatility is likely to increase.