New USD Interest Rate as Libor Alternative

The latest changes to interest rates is the Fed to move from USD Libor to a newly created interest rate to not replace Libor but to trade an alternative, a complement interest rate. Why the change is due to low liquidity and few Libor trades since the Libor Scandal and since Central Banks began wholesale changes to their respective interest rate systems.

Most important is to move the masses amount of monies tied to one interest rate as a market crash would devalue for example mortgages and other loans tied to Libor. As interest waned to trade Libor, the purpose to an alternative interest rate is to bring down the cost to borrow rather than rely on an uncertain interest rate whose price may skyrocket and again to diminish loans tied to Libor. Credit and much respect to Marc Chandler of Brown Brothers Harriman to bring this new rate to the attention of the traders.

USD’s system of interest rates are not only perfect but wholesale changes are impossible as the interest rate system has remained in place against slight changes since the 1860’s. Libor for all nations was the greatest change in the interest rate structure since the 1860’s as well as Fed Funds introduction in the late 1920’s.

Libor elimination required a wholesale change for all nations to revamp not only overnight rates but their own system of interest rates. The key to wholesale changes meant to devise a system separate yet specific to each nation but maintain proximity to USD interest rates as all nations are deeply depemdent on USD interest rates for not only currency price purposes but borrowing oosts, loans and trade. Further, all nations price their own inerest rates based on USD. See NZD for examples.
Libor since 1980’s introduction created an offshore vs onshore borrow and currency cost. The best example for interested and model purposes is Brazil as BRL for many years trades a specific onshore and Offshore interest rate.

Consider, Overnight Libor last reported at 1.44 Vs 1.42 Fed Funds. At 1.44 was the higher cost cost to USD, 200 basis points in overnight markets when American banks were closed Vs 1.42 in open American markets. The intent is to reduce 1.44 to a level in the vicinity of 1.42 yet far enough away to create a traded market. Between Fed Funds and Libor /Eurodollars, roughly $370 billion USD is traded daily and 90% of Fed Funds trades, $70 billion, are traded by 160 Fed banks to satisfy end of day surplus or deficit bank balances. (Fed).

What is seen from Libor elimination is the inward focus for all nations to concentrate on robust creation of interest rates specific to each nation but never stray from USD. The focus as is the new USD interest rate is very short term and liquidity creation. The new focus for central banks is creation of Risk free interest rates and the intent of the new USD rate is the Fed’s offer of a Risk free interest rate hence the 200 bps spread but consider 1.44 vs current 0.6 in 3 month swap rates and a hedge is created.

So new is the USD rate, the formal announcement comes today. What this new rate means for the currency price is unknown but libor elimination and diminished traded interest resulted in zero changes.

 

Brian Twomey