Short-term borrowing costs plunge

More signs of thaw apparent as money-market tensions ease

The cost of short-term dollar loans dropped more than expected Monday, a signal that money markets are slowly returning to normal after threatening to derail the global financial system earlier this month, economists said.

 The London interbank offered rate, or Libor, for three-month dollar loans fell to 4.05875%, down sharply from 4.41875% on Friday.

Libor, which is set each day in London, is an indicator of short-term borrowing costs in the arcane — but crucial — interbank lending market.

The rate remains abnormally high, but it’s climbed down from peaks set earlier this month as financial institutions all but halted loans to each other amid fears of further bank failures. The freeze in wholesale funding weighed on other types of lending, threatening a collapse of the credit system.

Concerns have understandably centered on the U.S. economy, the world’s largest.

The Philly Fed index reported last Thursday showed that credit woes have been pinching the manufacturing sector in the Philadelphia region during October. That sent the gauge to its sharpest one-month drop on record and its lowest reading in 18 years.  

Defining the ‘new normal’

“The good news is it’s a sign of a return to normalcy,” said Nick Parsons, head of markets strategy at NABCapital, referring to the signs of narrowing in the dollar Libor rate.

“But the new normal is not the same as the old normal,” he added.

What’s important is Libor’s level in relation to official interest rates.

In normal conditions, Libor closely follows official interest-rate expectations. But current three-month dollar Libor remains well above the U.S. federal funds rate of 1.5%.

Before the credit crunch, three-month Libor would be expected to hold in a range about one- or two-tenths of a percentage point above the fed funds rate.

Such spreads are unlikely to become that tight again, even after tensions ease, Parsons said.

The days of “cheap and plentiful” money are in the past, making it unlikely the spread will return to double digits, he said. Instead, a Libor spread a full percentage point above the fed funds rate is likely to become the new floor.

Libor is an important benchmark that is also used to calculate interest rates on mortgages and business loans, economists note. Elevated Libor rates can damage credit conditions for consumers and weigh on the broader economy.

Markets had been looking for a significant easing in Libor rates Monday, but the scope of the decline exceeded expectations.

Ahead of the daily Libor fixing, credit markets indicated traders expected three-month dollar Libor to fall to around 4.15%.

On Friday, three-month Libor posted its first weekly decline since July. The rate had pushed as high as 4.81875% on Oct. 10.

Monday’s sharper-than-expected drop provided an added boost to U.S. stock index futures.  

The Fed and the world’s major central banks have pumped hundreds of billions of dollars into the financial system through an unprecedented array of short-term lending operations in an effort to boost liquidity.

Some analysts have described last week’s decision by the Fed and European central banks to provide unlimited dollar funds as a crucial step toward breaking the logjam.

Lending rates in other currencies saw more modest declines.

Three-month sterling Libor fell to 6.11625% from 6.16% on Friday. The Bank of England’s benchmark interest rate stands at 4.5%.

And three-month euro Libor declined to 4.98625% from 5.02% on Friday. The European Central Bank’s benchmark rate is 3.75%.

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