Financial conditions are tightening globally, including the US, and LIBOR has been on the rise, accelerating beyond the overnight rate since mid-October indicating a potential new wave of dollar funding stress.
Given that LIBOR underpins more than $350 trillion in financial products, this new development is clearly a concern, but is likely more a symptom of increasingly tight liquidity than an indication of rising systemic stress.
Emerging markets (EM) have sold off deeply since late January and given the EM’s relative sensitivity to tighter liquidity, it is worth exploring the implications of rising LIBOR.
The last surge in LIBOR began about a year ago, rising nearly 100bps to 2.31 per cent. Then pressures eased, leaving the measure flat until the latest bout of tightening.
Back then, pressures were mainly attributed to limited dollar supply – from seasonal balance sheet realignment to tax reform related pressures, including corporate repatriation and increased deficits requiring financing.
Repatriation is most likely complete, but other drivers limiting supply remain in play. A deeper concern is the faster pace of contracting central bank balance sheets, which is accelerating in the US and moving to the ECB, and the Bank of Japan ending or reducing its own asset purchase programs.
A deeper concern is the faster pace of contracting central bank balance sheets
The net reduction of global central bank balancing sheets is tightening liquidity, which is contributing to dollar strength and could well be lifting LIBOR.
As the liquidity tide flows out, those most dependent on foreign funding and dollar flows are most at risk, as witnessed during the summer months with currency crises experienced in both Turkey and Argentina.
A full-blown crisis was averted (for now) through deep monetary and fiscal adjustments, but while EM broadly sold off in sympathy, it is telling that a deeper crisis did not spread.
We are cautious on EM, but selectively based on funding dynamics specific to individual sovereigns and corporates. Correlations and volatility have risen as a function of deteriorating sentiment, therefore net capital outflows across EM.
However, broad sell-offs often present buying opportunities – particularly where fundamentals are so divergent.
At the sovereign level, external deficits still matter, leaving countries such as Indonesia and India vulnerable to sell-offs.
However, dynamics have changed considerably since the taper tantrum in 2013, where both countries implemented numerous reforms greatly reducing external imbalances. As such, current high real yields offer an attractive risk-reward.
At the corporate level, EM debt levels are high and there is a fair degree of currency mismatch, but the risks are company specific as fundamentals are still holding up reasonably well despite tighter financial conditions and threats of a trade war.
EM corporate debt has sold off across the board where, again, selective buying opportunities have emerged.
The returning rise of LIBOR could very well expose the next weakest hand, but we are most concerned about the increasing drain on global liquidity driven by shrinking central bank balance sheets.
Will LIBOR’s rise lead to further dollar strength? It logically could, given the dollar shortage, but the relationship is not clear as dollar strength seems currently more driven by relative growth dynamics.
The liquidity tide is clearly receding, wherein distinguishing quality assets from value traps will become increasingly important. Current pressures lifting LIBOR look set to continue, particularly as the removal of liquidity by central banks accelerates.
Arguably, rates are simply normalising as levels are still low compared to history, but the transition will prove difficult for some whether it be in pockets of EM or DM. Like the rest of the world, EM includes both, so as correlations and volatility remain elevated, note that quality still exists and bargains are emerging.
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