All Eyes on Fed... But I’m Watching Libor Rates

As investors across the globe await the Fed’s decision later today, one indicator is signaling a strange (and perhaps frightening) disconnect with the widely-held belief that more Fed rate cuts will rescue credit markets.

The London Interbank Offered Rate (Libor), a key interest rate that big banks charge each other for overnight loans, remains at a stubbornly high level.

In fact, according to the Financial Times, the spread between three-month Libor rates, and the expected Fed funds rate three months down the road, remains unusually elevated at 60 basis points.

This is down from a “peak of 95 basis points prior to last month's rate cut by the Fed. But under normal conditions, the swap should trade around 8bp.”

Elevated Libor rates indicate a healthy amount of fear among banks and other financial institutions around the world. They clearly remain hesitant to lend to each other in the current environment.

Three month Libor is currently around 5.1%, while the Fed funds rate is 4.75%. But the Fed is widely expected to cut rates today by at least 25 basis points, with increasing odds of another quarter-point cut in December. Something just doesn’t add up.

In a normally functioning credit market, Libor should be no higher than about 4.6% (factoring in today’s likely move), and could be as low as 4.3% (in the event of a 50 basis point easing by the Fed), but Libor is stuck at much higher levels than this.

Libor is signaling one of two things: either the world’s banks don’t believe the Fed intends to cut rates much further – or they doubt such easing will do any good for what really ails credit markets.

Either way makes for a potential nightmare on Wall Street this Halloween!