LIBOR Rates Finally Easing; Riskier Credits Still Declining

By Eric Roseman

For the first time since July, LIBOR rates have started to ease. That's good news for global investors as recent government guarantees to protect banking systems begin to show some effect.

On Monday morning, three-month LIBOR sat at 4.05%, down sharply from 4.42% on Friday and 4.81% on the previous Monday morning. The Federal Funds rate, set by the Federal Reserve, is at 1.50%. Typically, in a normalized credit environment LIBOR trades about 50 basis points or 0.5% above the Federal Funds rate. Similar overnight lending rates across Europe and Asia are also declining this week.

LIBOR, or the London Interbank Offered Rate, is a crucial U.S. dollar lending rate tied to over US$360 trillion dollars' worth of financial products worldwide. Since last year, the LIBOR rate has remained historically high.

Critics of the rate blame the British method of calculating the index. Several months ago, American bankers in New York calculated a new model to determine if London LIBOR rates were accurately reflecting the nervous state of interbank lending markets. The results concluded London LIBOR is indeed accurate.

This is only a minor decline considering the vast amounts of capital pledged to be injected in global banking systems. But the fact that interbank lending rates have begun to normalize is a positive development.

The market is starting to price a relaxation of credit stress. Of course, this process won't happen overnight because government guarantees will take time to filter through the broader global economy. Still, this is very good news for nervous investors.

But junk bonds, emerging market bonds, convertible bonds and other risky credits have continued to decline this week. Truth be told, I'd be more encouraged about LIBOR's progress this week if this rally was confirmed by tightening credit spreads for high-risk bonds. Unfortunately, that's not happening.

I'm standing by my forecast from two weeks ago that global stocks are extremely oversold and poised to rally following weeks of relentless selling. Lower LIBOR rates are a plus.

However, don't be fooled by new bull market chatter; this remains a secular bear market for stocks as the economy digs deeper into recession over the next six months. Use any rally as another opportunity to sell unwanted stocks and remain highly liquid. Before this is over, the Dow should test or re-test its October 2002 low of 7,286. The economy is far worse today compared to the last recession six years ago. Stay defensive.