LIBOR and the Stock Market: What Investors Need to Know

The reaction to the European Central Bank's action today was amazing.  As we examine the various reactions, we note some patterns.  These tendencies offer an opportunity to investors willing to do some work to gain understanding.

Today's Reactions

As we noted yesterday, the ECB stepped up to provide temporary loans to banks needing to meet year-end requirements at below-market rates.  The main takeaway, as we noted yesterday, should be the determination of central bankers to restore normalcy in credit markets.

This is part of a central bank approach to target liquidity as well as making overall reductions in interest rates.  We have noted the clear distinction between how economists view these actions, and the response of stock traders.

A sampling of today's reaction includes the following:

Briefing.com.  (You need to subscribe to the premium service for this one, but this is the key quote.)  "if the ECB had to go so big" what kind of trouble is really out-there angle?

Calculated Risk (one of our featured sites) offered the news story without comment.  You need to follow the link and read the comments to see the reactions of the readers of this very popular source.  For those to lazy to do so, the audience is skeptical -- very skeptical -- and not too informed on the nuances of how various LIBOR rates are determined.  Please note.  It is not our intention to be critical of the Calculated Risk audience.  We think they are intelligent with a lot of information on many issues.  That is the problem.

Michael Shedlock.  We check out the Mish site only occasionally, so we are indebted to gaius marius (who often raises intriguing points, usually on the other side of our own perspective.)  Mish notes, among various other conclusions, that the ECB move did not affect the US yield curve.  We wonder why anyone would have expected such a reaction.  It seems to miss the key point of the various central bank actions.  This is another of the big-time readership sites, so it is a good read on what people are seeing and thinking.

MarketBeat, read by those establishment types who hope that David Gaffen will explain the mysterious, includes a strange statement about the lack of impact on "US LIBOR in the US."  The article includes several quotations from authorities, none of whom draw the distinction among the 150 different LIBOR rates posted every day.  Our hope is that Gaffen will take a leading role in improving understanding on these important differences.

A Few Facts

LIBOR rates are determined by a daily survey of a panel of big banks conducted by the British Bankers Association.

There are 150 different LIBOR rates.  Their website describes as follows:

There are 15 different maturities for each currency and day of fixing. The shortest maturity is overnight (O/N) for Euro, US Dollar, Pound Sterling, and Canadian Dollar and spot/next (s/n) for all other currencies. 1 w stands for 1 week and 1m stands for 1 month. The longest maturity for which BBA LIBOR is fixed is 12 months.

Readers need to know the following:

• Much of the popular discussion of LIBOR moves relates to other currencies, not dollars.
• The relevant discussion of LIBOR rates in US dollars pertains to so-called "eurodollars."  These are dollar deposits held outside the US (not necessarily in Europe).  These deposits are 20%+ of total dollar reserves.
• The rate is determined by a panel of banks trading in eurodollars.  They are big players in this market, but not necessarily US based banks.
• There is only a loose arbitrage between Eurodollar trading and rates in the US.  Many of the banks involved cannot move between the two markets, for example.
• The LIBOR rate most important to the US housing market is the six-month maturity, linked to some ARM's.  This is not the rate that you read about most frequently.
• US investors can trade Eurodollar futures at the CME.  Many people do not understand that this is an interest rate instrument with very deep liquidity and a history of over twenty-five years.

Conclusion

Tomorrow's announcement of the Fed's first TAF auction is likely to be greeted with the same level of misinformation as today's ECB announcement.  The real test of these central bank moves will come after a period of time.

If the Fed and other central banks succeed in getting liquidity where it is needed, there will eventually be an effect.  They see the problem as one of targeting rather than (or in addition to) the overall rate level.

As long as equity traders do not understand this, there may be a good investment opportunity for those willing to do some homework.  As we wrote in not fighting the Fed, and not fighting the ECB, it is a rare opportunity to take advantage of something that everyone should know, but does not.

There has been a breakdown in the normal educational sources here, a topic that we will explore in future articles.

Comments

[Hedge Fund]

I don't know if the worst is over or not. Many of my friends are still holding lots of cash because of their similar feelings. Who would have thought that bear would go down?

- Richard
Hedge Fund Consulting Blog
http://richard-wilson.blogspot.com

[Albert]

I am not that worried about the markets now. Most of the bad news are out now. I think that we are in some kind of flat correction.