What's Up (Down) with Libor?

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The benchmark three-month LIBOR continues to fall. Since last Friday, it has fallen by about 8 bp, more than in the whole month of March. In April, three-month libor fell about 20 bp and thus far this month it has fallen another 16 and counting. The LIBOR-OIS spread has also fallen sharply. It fell 9 bp today to bring this week's decline to 17 bp, after declining only about 5 bp last week. This closely followed spread (.uslibois on bloomberg) is now a little above 57 bp the lowest in nearly more than a year. It had averaged above 11 bp, according to Bloomberg data, in the five years before the financial crisis.

The meaning and significance of this is a matter of dispute. Many observers embrace the fall in LIBOR and the narrowing of the LIBOR-OIS spread as a sign that banks trust each other more and that interbank lending is improving. The normalization of such credit-quality spreads were widely anticipated to signal the end of the crisis.

Yet it doesn't feel like it. There are a couple of other factors that suggest that there may be more to the decline than meets the eye. First it is widely acknowledged and documented that American savings are rising. Where are they putting the money? Some $400 bln has been deposited at the banks, where the FDIC guarantees the funds. It is safe and liquid. These banks then may parking some of the funds in the LIBOR market, pressing rates lower.

However, all banks are not perceived as equal of course and one of the notable developments has been the widening of the underlying rates submitted to the British Bankers Association that continues to provide the LIBOR fixing rates. Today, the spread between the most aggressive bank (lowest rate) and the least (highest rate) is 26 bp. This is a relatively large dispersion given that the rate was fixed at 85.4 bp. Yesterday the spread was 30 bp.

It seems too early to arrive at hard and fast conclusions. However, the decline in LIBOR may not be the evidence that some first hoped it would be that the financial crisis is ending. It could be, but there seems to be some other complications whereby the decline in LIBOR, which is driving the narrowing of the LIBOR-OIS spread is a function of the crisis itself, perhaps even signs of a liquidity trap. We will continue to monitor this development for you.