The biggest developments in the market and economy this week were the decline in the value of our greenback and the move higher in long term interest rates (10yr U.S. government bonds moved to 3.46%, a level not seen since last Fall).
Despite these concerns, many analysts will point to the drop in Libor (London interbank overnight rate) as an indication of the increased confidence in the global banking system. I strongly disagree.
I believe the drop in Libor is not a reflection of the “fundamental” improvement in our global banking system, but rather a “technical” reflection of the supply of dollars that have been injected into the global economy. There is an enormous difference in these lines of reasoning and the implications they have for our markets and economy going forward.
If Libor were declining because of a “fundamental” improvement in the global banking system, it would be reflected in an increased flow of credit into the economy. That flow is not happening.
If Libor is declining because of a “technical” supply of dollars, then it would be reflected in a decline in the value of the dollar, an increase in long term interest rates, an increase in the prices of select commodities (gold has rebounded to $957/oz, oil is back above $60/barrel), and other inflation-related variables. Yes, we are seeing all of these developments.
Let’s revisit my post from May 15th, What Is Going On With Libor?
While many analysts were promoting the drop in Libor as a positive, I begged to differ and wrote:
Has the drop in Libor coincided with an improvement in the credit markets? No. Despite what pundits would tell you, credit spreads remain at elevated levels. In fact, on an inflation adjusted basis, rates are at the highest levels since the early 1980s.
Why aren’t banks lending as much? Lack of confidence in the economy along with enormous embedded losses in their current book of loans. Those losses are real and will be rising. The elusiveness of bank credit is highlighted in a McClatchy article, Businesses Struggle as Bank Loans Remain Elusive, in the Newsworthy section of Sense on Cents.
Thus, if a drop in Libor is not a reflection of improved credit conditions, what does it mean?
In my opinion, it is a precursor to a drop in the value of the dollar. Why?
Very simply, too many greenbacks floating around. A decline in the value of the dollar is inflationary. Both core rates of producer prices and consumer prices reported this week were higher than expected. I’ll be watching.
Please recall, there are always three factors that determine the level of a market: fundamental, technical, psychological. A move in Libor is almost always analyzed from a fundamental standpoint. However, in our Uncle Sam economy, we need to be increasingly diligent in reviewing all three of the aforementioned factors along with the implications they have for our global markets as we navigate the economic landscape.