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LIBOR Drops But Short-Term Credit Markets Remain Tight

By Jennifer Yousfi
Managing Editor
Money Morning

Short-term lending rates fell after a week of unprecedented government intervention in the global financial markets helped to encourage banks to resume lending.

The dollar-denominated three-month London Interbank Offered Rate (LIBOR) dropped 40 basis points over the course of the week to 4.42% – its first such decline since July. Short-term rates quoted in euros and yen also dropped.

The overnight rate hit 1.67% – reaching its lowest level since September 2004 – after it dropped slightly more than a quarter percentage point last week.

“LIBOR rates continue to edge down, bringing the prospect of some rejuvenated interbank lending that little bit closer, even if it is still some way distant,” Daragh Maher, deputy head of global currency strategy in London at Calyon, the investment-banking arm of French lender Credit Agricole SA, told Bloomberg News.

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Despite last week’s decline, LIBOR remains well above central bank target rates. At 4.42%, the rate is well above the benchmark U.S. Federal Funds rate of 1.50%.

“Contrary to what most people think, the Fed Funds rate is a ‘target;’ it is not an absolute number that anyone actually has to follow,” Money Morning Contributing Editor Shah Gilani said in a recent analysis.

The Fed, along with other central banks, has lowered target rates in hopes of encouraging lending in the short-term credit markets. But it’s taking time for the effects of the Fed’s Oct. 8 rate reduction to work its way into the global financial system.

Earlier this week, U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. announced plans to recapitalize U.S. banks with $250 billion in cash infusions. Switzerland, the United Kingdom and others announced similar plans to help ailing financial institutions.

But for now, banks remain risk-averse and are holding onto cash. The commercial paper market, which many companies use to fund daily operations, continues to shrink. For the week ended Wednesday, the Fed announced the amount of commercial paper outstanding shrank by $40.3 billion, reaching $1.51 trillion on a seasonally adjusted basis.

The short-term market, which is usually highly liquid, is down from $1.81 trillion in late September, and down from the peak of $2.2 trillion reached in the summer of 2007, The Associated Press reported.

“The market is starting to believe that central banks’ policy actions are taking out some of the financial systemic risk,” Craig Saalmann, a Sydney-based credit strategist with JPMorgan Chase & Co. (JPM), told Bloomberg.

While it’s taking out some of the risk, it certainly isn’t squeezing out all of it: The short-term credit market won’t return to more normal conditions until banks can regain confidence in their peers, Money Morning’s Gilani wrote in his Oct. 10 analysis of the Fed Funds target rate.

“Just because the Fed floods banks with cash doesn’t mean that banks will lend each other money – at the targeted Fed Funds rate, or at any rate,” Gilani wrote. “Banks are all fearful of each other – I’m talking on a worldwide basis – they are increasingly hoarding cash as a cushion against their own upcoming losses.”

News and Related Story Links:

More on this topic (What's this?)
On The Uselessness Of LIBOR (Zero Hedge, 6/21/09)
Why you care about LIBOR (The Curious Investor, 10/21/08)
The latest on LIBOR, rate cuts, and other eff… (Interest Rate Roundup - Money an..., 10/7/08)
"Are Central Banks Making Libor WORSE?" (naked capitalism, 10/10/08)
Read more on LIBOR, 2007 Credit Crunch at Wikinvest
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