Libor, Currencies & Inflation

There are two broad subjects that I like to research and occasionally write about. Both are very broad but perhaps surprising to a lot of people there are often cause and effect links between them. The first is change management and improving business performance, and the other is finance, economics and investing. Finance, economics and investing are indeed subjects in themselves but there are so many joins and overlaps between them that it’s often hard to cover one without referring in some way to the others.

On the face of it LIBOR (Intercontinental London Interbank Offered Rate) appears irrelevant to most people and is often only vaguely understood by those outside of the financial services industry. Like the FED funds rate LIBOR is a global benchmark rate; in other words it is important.

I’ll resort to Investopedia for a full definition:

‘LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF), and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate.

LIBOR (or ICE LIBOR) is the world’s most widely-used benchmark for short-term interest rates. It serves as the primary indicator for the average rate at which banks that contribute to the determination of LIBOR may obtain short-term loans in the London interbank market…..’

What is slightly more interesting feature of LIBOR is that ‘…it helps to evaluate the current state of the world’s banking system as well as to set expectations for future central bank interest rates.’

It is this latter comment which is perhaps of more interest. With the notable exception of the Federal Reserve and, some would say, its quixotic notions of increasing interest rates, most of the world’s central banks are positioning lower or ‘low for longer’ interest rates. Dollar LIBOR seems to support this. If we look at a chart for the past few years there is a noticeable increase in rates. Each of the standard maturities are showing tangible increases with the trend starting somewhere towards the end of 2014. The Brexit vote in mid-2016 interrupted this trend but as you can see from the chart, within a week or two the earlier upward trend re-established itself rather quickly.

The FRED chart of U.S. bank excess reserves is also of interest. Peaking in August 2014 at $2.7 trillion it started a downtrend about the same time as Dollar LIBOR started to move upwards. Given the subject matter, availability of money, it seems reasonable to assume that the two things are connected. In other words demand for money has been increasing and it is being sourced from US bank excess reserves deposited at the FED. As of the end of July 2016 these reserves had dropped to $2.2 trillion, representing almost $500 billion only recently injected into the U.S. economy.

For information U.S. ‘excess reserves’ basically represent cash held at the Federal Reserve above the minimum the FED requires banks to hold on their balance sheets. It is a nuance of the U.S. banking system which is why you don’t see reference to it in UK discussions. Excess reserves rocketed upwards in alignment with the $4 trillion QE money printing exercise initiated in 2008 following the banking crisis. Starting in 2008 the FED used QE to buy assets from the private sector while at the same time announcing that interest would be paid on any private bank cash deposited back at the central bank. Given the waning appetite of business to borrow and a significantly increased reluctance by the banking system to lend, much of that QE cash swilling around the private banking system did not end up getting loaned out to business but was re-deposited with the FED. US banks took the view that low risk FED interest was a much better bet than lending to business in a shaky post-2008 business environment. Some QE did filter out into the real US economy but a massive amount ended up back with the FED. In other works the stimulus real economy effect of Dollar QE was muted at best.

Rolling forward to 2016 and demand for dollars has been slowly increasing, represented by Dollar LIBOR rates edging upwards. It is therefore moot as to whether we could see U.S. inflation also edge upwards. Much will depend on how fast this $2.2 trillion of excess reserves finds its way into the real U.S. economy. Currently ‘locked-up’, the money might as well not exist. But if hundreds of billions are released into the U.S. economy over a short period of time then there are bound to be consequences for the value of the U.S. dollar. More dollars chasing the same goods and services ultimately translates into inflation in one form or another, both in consumer prices and hard assets.

If U.S. inflation lurches upwards the FED may need to act to prevent a sharp fall in the value of the Dollar. At the moment the Dollar is regarded as ‘the cleanest dirty shirt in the laundry’ and remains the favoured currency in volatile and capricious markets. A Brexit vote and Cable moves in favour of the Dollar; a Eurozone crisis and the Euro falls and the U.S. Dollar increases. However, a sharp increase in U.S. money supply sourced from U.S. bank excess reserves and sentiment could well shift in favour of those other currencies, including of course gold. While the longer term goal of the FED is probably to help inflate away the ballooning U.S. debt (projected at $20 trillion by early 2017) short sharp drops are not usually regarded as desirable.

The FED is somewhat cornered. It needs a gradual drop in the value of the Dollar but would also like to increase rates in preparation for the next crisis. Notwithstanding the claims of the Democrats and the (allegedly) goal-seeked BLS economic statistics, outside of the large cities the US economy is not generally in a healthy state. A dose of inflation would probably help get things moving but the FED will not be able to achieve this if it starts putting rates up. Indeed, the opposite is a more likely result. For this reason there doesn’t appear to be much of an immediate case for increasing US rates in the foreseeable future, whatever the periodic ruminations of FED members. Nonetheless an increase in inflation above 5% and the FED could have its hand forced, whatever the longer term benefits of eroding the real value of US debt.

Back in the UK the BoE is still positioning a ‘low for longer’ policy, perhaps capping the current ‘crisis’ interest rates until 2020. Sterling LIBOR still supports these signals but a structural change in U.S. Dollar sentiment could well force a re-think of this intent. The current ‘Brexit bonus’ of a 10% drop in the value of the Pound could evaporate just at the time we need it most: during the uncertain two year countdown to formal exit from the EU.

In a world driven by central bank interventions forecasting is virtually impossible; even directional thinking is a tough challenge. Nonetheless herewith are some thoughts. If the US is about to experience higher inflation rather than the more widely assumed deflation there will be some consequences for Cable. Sterling could well increase against the Dollar which will put the BoE in an equally challenging situation. With Brexit fear and potential further EU referendums over the next couple of years the Euro could also drop in value against Sterling.

What short term strategy could the BoE deploy if faced with a currency increasing in strength against its major trading partners? How will the UK Treasury and BoE manage the UK’s own burgeoning national debt load, already exceeding £1.6 trillion? Faced with a shorter term challenge of a rising currency and the longer term problem of a growing national debt it really has few moves available. It no doubt feels that it must keep rates at low levels for as long as possible. Alas another 25 basis points fall in UK interest rates and the country risks entering the Twilight Zone world of negative interest rates.

Interest rates have now been at these crisis levels for eight years. Failing banks have been protected but at the expense of current and future pensioners. Defined Benefit pension funds are mostly in deficit with bond yields at their lowest in hundreds of years and asset values in bubble territory. The economic infrastructure is creaking under the weight of systemic and polarised financial forces pulling in all sorts of directions. Add Brexit uncertainty and a global slowdown to this and the prognosis for the next few years looks less than healthy for the UK economy. Even if Brexit acts as a palliative factor the implications of continued lower interest rates look more likely to hinder economic progress rather than help it. The BoE looks like it is as cornered as the FED with many of its remaining ‘new normal’ economic manipulation tools now looking very blunt indeed. What exactly is the point of lowering interest rates even further and what evidence is there that this strategy still has any residual stimulative economic benefit, if indeed there ever was any?

Whatever the choices of the FED, BoE and ECB economic activity looks more likely to decline rather than increase. This of course suggests that businesses should be starting to look at 2017 and 2018 as revenue challenging and should thinking about paring costs to align with those less than stellar increases in income. The better companies undertake scenario analysis, plan and prepare in the good times rather than wait to see declining revenues on their profit and loss statements. Now is the time to think this through and take action rather than put your hands together and pray that the central banks, economists and political class know what they are doing.

The dénouement of the great monetary experiment could soon be upon us.

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