What’s Going On with LIBOR?
The views and opinions expressed in this article are solely those of the author and do not represent the views of Fifth Third, its Board of Directors, employees or shareholders.
Every once in a while, financial markets require new instruments to support a vast number of transactions that once relied solely on a single, but important, interest rate. Such has been the case with an international interest rate on which some 350 trillion dollars’ worth of derivative and bond market trades have been based.
LIBOR, also known as the London Interbank Offered Rate, has, for decades, been a reference interest rate that determined the price of money in global financial markets. The official definition of LIBOR is the “average interest rates at which leading banks borrow funds from other banks in the London Market.” That rate today is roughly 3% and tracks relatively closely to other short-term interest rates like the Federal Funds rate in the U.S., now hovering somewhere between 2.25% and 2.5%.
Alas, by 2021, that will no longer be true. LIBOR has fallen out of favor for several reasons, not the least of which was an illegal manipulation of LIBOR that led to a hefty amount of ill-gotten gains among several large banks, mostly European. As a consequence, international financial regulators launched a move to replace LIBOR with one or more new interest rates that will determine the cost of funding not only of large professional transactions, but also some consumer interest rates as well.
You Might Be Wondering, “Why Do I Care?”
Well, for one, some mortgage rates are based on LIBOR and certain types of bond market investments have also been influenced by the level of LIBOR. Having said that, the bulk of consumer interest rates, especially in the U.S., will still be determined by what the Federal Reserve does with interest rates going forward.
During its last meeting at the end of January, the Fed left interest rates unchanged and suggested it would not only be patient in raising rates in the future, but would also be flexible in setting policy going forward. In other words, the Fed could lower rates as easily as raising them, if the economy were to weaken further. Domestic interest rates have since fallen, which will be likely to push mortgage, and other consumer interest rates, lower in the weeks and months ahead.
Still, finding a suitable replacement for LIBOR is critical to the proper functioning of global financial markets between now and 2021 when LIBOR will be, effectively, phased out. Between now and then, for those who pay close attention to international interest rates, they will see an alphabet soup of new replacements, from SOFR to SONIA. The Federal Reserve has developed SOFR, or the Secured Overnight Financing Rate, based on activities in the U.S. bond market. For SOFR, its adoption can be characterized as so far, so good. SONIA, meantime, the Sterling (British Pound) Overnight Index Average, is also a British-based rate that is beginning to gain some traction in pricing bond offerings and determining the performance of floating-rate notes and other fixed income investments that even individual investors may own.
It is safe to say that, going forward, replacing LIBOR will take some time and experimentation on the part of global central banks, and the international banking community as well. It will pay to watch this, with at least one eye open, to determine if the replacement for LIBOR will ultimately affect the behavior of your bond portfolio. The jury remains out, but given the divergent paths of global interest rates, paying attention may pay off if there is a sudden, and important, shift in the cost of short-term money.