InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
OCTOBER 19, 2016
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We have previously published in IntelDigest several discussions of short-term interest rates around the world, and the consequences for millions of people affected by the actions of The Federal Reserve and other central banks in forcing such rates down. Short-term rates have fallen to almost-Zero … below-Zero in some countries … over the last seven years.
Today, we’ll discuss a commonly-used interest rate that has risen by 44% so far this year, and the central banks have little or nothing to do with it. We’re talking about LIBOR, the London Interbank Offered Rate.
LIBOR is a benchmark interbank rate which many leading banks use to charge each other for short-term loans. It is often the foundation, or first step, in calculating rates for millions of loans around the world … in all likelihood, your own home mortgage loan is calculated using LIBOR.
We won’t go into a technical description of LIBOR; instead, we’ll discuss why it is rising so fast while other rates are stuck.
According to Bloomberg Markets, $7 Trillion of debt … corporate bonds, student loans, mortgages, et al … are based on LIBOR rates. The 3-month U.S. Dollar LIBOR rate has gone from 0.61% to 0.88% in just over nine months, and is expected to keep rising. This initial increase will raise interest costs on the outstanding loans by Billions of Dollars!
This is setting the stage for a possible credit crisis within the next 2-3 years.
Securities and Exchange Commission Rules
Why is this happening now? LIBOR has not made a significant move since 2008. Many analysts believe that it is a response to new SEC regulations which have gone into effect this month. The regs apply specifically to money-market funds … an attempt to reinforce an industry which was in the middle of the 2008 financial crisis.
As reported in Bloomberg Markets, the new rules require prime money-market funds … an important source of short-term funding for banks and businesses … to “build up liquidity buffers, install redemption gates, and use ‘floating’ net asset values (NAV) instead of a fixed $1-per-share price.”
The NAV requirement does NOT apply to government and retail money-market funds, which can still offer stable net asset values. But, it DOES APPLY to funds which invest in short-term debt securities and work with retirement plan sponsors . Such institutions now have to allow their prices to fluctuate daily based on the market value of their holdings.
The “redemption gates” and “liquidity buffers” apply to both institutional and retail money-market funds, but NOT government funds. These provisions allow some funds to temporarily suspend redemptions or impose liquidity fees on investors who try to withdraw money during volatile periods.
Stresses in the Banking System
Bloomberg Markets has recently reported that $1 Trillion have been shifted from prime money-market funds to government funds over the last year (the new rules were published last Fall). The competition among banks to replace these lost Dollars would seem to be a cause for LIBOR rates to spike. Rates last spiked like this in September, 2008 when Lehman Brothers filed for bankruptcy.
When there is high uncertainty or panic in the banking system, banks charge each other very high LIBOR interest rates.
Stresses in the Economy
In previous issues of IntelDigest, we have discussed many of the strains on our economy, which include decreasing corporate earnings, especially at the banks, increasing corporate defaults on debt, and massive borrowing by U.S. corporations at low interest rates.
Corporate profits have NOT kept up with borrowing. As LIBOR rises, interest costs increase for all borrowers. At the same time that corporate earnings are headed down, debts are becoming more expensive. This is a problem for our economy!
Addressing the New Money-Market Rules
Money-market funds have traditionally been a safe haven in times of market stress, but you may have to avoid such funds in future.
Money-market funds may no longer be an option in many retirement plans, or you may choose not to live with the possibility of having to pay a penalty for withdrawals during volatile periods.
You, as the investor/retiree, will have to decide how best to invest monies which had been held in cash or cash equivalents in the past. The safest, but lowest-yield, alternative is usually a government money fund investing in short-term U.S. treasury bonds. Financial institutions may also offer money-fund replacements such as stable-value funds, short-duration bonds, guaranteed investment contracts, or certificates of deposit.
Recognition of Danger in the Economy
Rising LIBOR rates will have a profound effect on the economy, and there is little that The Federal Reserve can do to change the situation. Market forces are in control.
The first step is to recognize the problems:
Be aware that the economy is slipping into recession
Be aware that the stock and bond markets are in danger of sharp corrections in the coming months
Be aware that, if LIBOR rates continue rising over the next two years, a serious credit crunch will hit in 2018-19
Steps to Take Now
We repeat the analysis published in the August 31 issue of IntelDigest:
1. All investors should analyze their portfolios to determine if the dividend is sustainable in each of their dividend stocks. A sure sign of trouble is a company which pays more in dividends than it earns in profits.
2. Look for companies with proven dividend track records. For example, if a company has increased its dividend for more than 10 years in a row, you know it can manage its dividend through ups and downs of the business cycle. Those are the companies that we want to hold for the long haul.
3. Try to avoid companies with significant indebtedness. If there are serious problems in the economy over the next year or two, many companies will struggle to make money. Companies with too much debt may have to cut their dividend, or stop paying dividends entirely, in order to pay their debts.
4. In these “unusual” times, investors should have positions in gold, and should consider holding 10% to 15% of their money in gold. This small position could protect against catastrophic losses if stocks plunge.