Libor (London Inter-Bank Offered Rate) is the average interest rate estimated by each of the lending banks in London that it would be charged were it to borrow from other banks. As short-term interest rates rise, of course, the overnight rate will rise as well. A rising Libor rate is two-fold, however. A rising Libor rate can also indicate tightening credit and liquidity conditions. Banks are less willing to lend out overnight loans as market risks elevate.
With that said, the Libor rates from the 1-week to the 12-month duration can be seen at the highest of the economic cycle. I am not a market technician and do not believe in trend lines and similar technical data points but I would be remiss not to show the long-term chart of the Libor rates without the long-term trend line.
Each economic cycle shows a lower peak in Libor rates, similar to the Federal Funds rates, the 10-year Treasury rates, the nominal GDP growth rate and the inflation rate. All of these factors are correlated.
As the chart below shows, the Libor rates are at the highest since 2008.
The major issue with rising Libor rates is the increased debt service cost incurred by loans linked to Libor. The Telegraph reported that "A third of all US business loans are linked to Libor, as are most student loans, and 90pc of the leveraged loan market."
With an economy overloaded with debts, most of which are linked to Libor, it is not surprising that a rise in Libor rates and short-term interest rates precedes the end of each economic cycle. Libor rates and short-term interest rates rise, causing debt-service payments to increase at the end of a business cycle. Debt service payments end up growing faster than income and defaults occur, triggering the end of the business cycle.
Each economic cycle ends with a lower terminal rate in both Libor and short-term Treasuries, including the Federal Funds rates, because as aggregate economic debt increases in nominal terms, it takes lower interest rates to create a rapid acceleration in debt service payments. In other words, the economy is leveraged to short-term interest rates, given the percentage of loans linked to Libor as stated above.
The four critical sectors of the economy - Federal Government, State & Local, Household, and Corporate - have an aggregate $70 trillion of debt. This is an increase of roughly $20 trillion from the last recession, i.e., the $50 trillion level of 2008.
In terms of GDP, total debt has risen to a staggering 370% of GDP. (Still lower than Europe, China, and Japan, but that is a topic for another day.)
Total US Debt To GDP:
Debt has risen substantially in all four categories but most notably in the corporate sector this economic cycle. Each cycle has one sector that adds far more debt than the rest, or at least at a faster pace. Last cycle it was the consumer in terms of mortgage debt, and this cycle it is the corporate sector. The corporate sector has added a trillion dollars of mostly short-term Libor-linked debt since 2008.
A rise in interest rates on $70 trillion of total debt works out to be a very material hit to disposable income.
The rise in short-term interest rates will have a much more severe economic impact than most investors believe due to the level of indebtedness in the economy.
As the Telegraph reported, most debt is short term and linked to some duration of Libor. On $70 trillion of aggregate debt, assuming a generous 35% of the debt is linked to Libor in some fashion, that works out to a little less than $25 trillion of debt that will have interest payments roughly 200 basis points higher. 2% on $25 trillion of debt works out to be an increase of debt service payments on the order of $500 billion annually.
Of course, these are very rough estimates and not exact at all but the impact to national income is vastly underestimated by the market at this time. The market, for this reason, is also overestimating growth expectations. By the second half of 2018, when the economy is hit with a $500 billion (or so) increase in annual debt payments, growth will contract materially.
1-Month Libor Rate:
The 1-month Libor rates have surged along with short-term treasury rates from roughly 20 basis points to nearly 1.70%.
3-Month Libor Rate:
The 3-month Libor rates have soared north of 2% from roughly 0.30% just two years ago.
The 12-month Libor rate has hit 2.50%, the highest since 2008.
1-Year Libor Rate:
I believe the market is dramatically underestimating the impact of rising short-term rates given the level of economic debt. The rise in interest rates, due to the debt level, will have a much more severe negative impact on growth, income, and consumption than the tax cut will help. In this case, the debt outweighs the tax cuts.
Again, I point out the lower highs in the 1-year Libor trendline below. Is this the peak in rates? It would make sense that once the economy has one round of annual payments at these rates, given the level of debt, that growth slows materially enough to warrant a halt in the rise of short-term rates.
12-Month Libor Rate:
Another spread worth noting is the Libor-OIS spread, as the Telegraph reports: "the 'Libor-OIS spread’ – watched carefully by traders – has risen to levels reached during the onset of the Chinese currency crisis in early 2016, and during the onset of the Italian and Spanish funding crisis in late 2011."
The technical definition, "An overnight indexed swap ((OIS)) is an interest rate swap where the periodic floating payment is generally based on a return calculated from a daily compound interest investment. The reference for a daily compounded rate is an overnight rate (or overnight index rate) and the exact averaging formula depends on the type of such rate."
From Wiki to help understand the spread: "The LIBOR–OIS spread is the difference between LIBOR and the OIS rates. The spread between the two rates is considered to be a measure of the health of the banking system. It is an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets. A higher spread (high Libor) is typically interpreted as an indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as an indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes." CLICK HERE
Libor-OIS Spread Rate:
The Libor-OIS spread has risen to the highest level since the Chinese currency devaluation which roiled markets back in 2016. Why is the spread rising today? Typically, a rising Libor-OIS spread is indicative of heightened economic or systemic risk.
I have outlined in many recent articles that I believe the US economy is slowing, which is entirely consistent with a rising Libor-OIS spread, rising credit spreads, decreased bank lending growth, falling money supply growth (M2), and a flattening yield curve, all of which are occurring today.
The market is severely underestimating the risk of rising interest rates in an overindebted economy along with many growth slowing indicators flashing red.
Some have argued that the rising Libor-OIS spread is due to a dollar shortage, linked to tax repatriation from the new tax code. While this may be possible, it would not explain the dozens of other factors that are also indicating growth slowing and heightened risk for recession towards the end of 2018 and beginning of 2019.
It is my view that the rising Libor rates and the increasing Libor-OIS spread are a result of the reduction in liquidity and tighter credit conditions by the Federal Reserve in conjunction with a slowing economy. The near-term risk in the market is rising.
This article was written by
Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.
Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives.
Eric holds a Bachelor’s degree in economics from New York University.
EPB Macro Research offers premium economic cycle research on Seeking Alpha.
Disclosure: I am/we are long SPY, TLT, IEF, SHV, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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