Defaults Won’t Stop Funding Frenzy Started by Central Banks

(Bloomberg) -- In a world riven by disease and credit risk, traders are betting central bankers will pin down global borrowing costs for years to come -- regardless of the consequences.

With banks awash with cash, money markets are signaling that unsecured lending rates will stay near historic lows across Europe and the U.S., even as rising corporate bankruptcies add pressure to bank balance sheets.

Eurodollar futures, benchmarked to the three-month London interbank offered rate for dollars, suggest borrowing costs will barely budge until at least the first quarter of 2023. Funding gauges in other parts of the world paint a similar picture.

Of course, freeing up liquidity was part of policy makers’ motivation for cutting interest rates to near zero, and in that they’ve succeeded. But these moves have also stoked concern about central bank-spurred asset bubbles, as low wholesale rates encourage businesses and households to gorge on debt.

“Moral hazard is absolutely rampant,” said James Athey, investment director at Aberdeen Standard Investments in London. “There are some very disturbing outcomes possible: default, depression. And the more liquidity is pumped into the system without production to back it up, the more outright currency debasement there is.”

The Federal Reserve eased wholesale financing conditions with its actions earlier this year, helping the credit cycle to pull back from the pandemic abyss and then boom anew.

However, measures to fight the coronavirus outbreak continue to exact a heavy toll on corporate balance sheets. The U.S. has seen more big companies go bankrupt through July 20 than in any full year since 2009, according to data compiled by Bloomberg.

Counterparty Risk

All that makes it easy to fret over the counterparty risks faced by banks and their potential to affect Libor, which remains a backbone of the financial system even with it due to be replaced in the U.S. by the end of 2021. Bankruptcies could confront lenders with a surge in non-performing loans. And any increase in the commercial paper rate that banks use to inform their Libor submissions would push the benchmark higher.

Yet traders remain steadfast in the belief that policy makers will ensure any rise in interbank rates will prove short-lived.

“Central banks would step up very fast and ease the funding pressures for the banks by increasing the amount of liquidity,” said Bob Stoutjesdijk, a Rotterdam-based fund manager at Robeco Institutional Asset Management.

Over at BMO Capital Markets, U.S. rates strategist Jon Hill reckons three-month dollar Libor could hit a fresh record low in the next 12 months. The rate set at 0.26063% on Wednesday, about four basis points above an all-time low.

“Although the Federal Open Market Committee technically targets the federal funds rate, Libor arguably matters more for aggregate financial conditions,” he said.

It’s a similar story in Europe, where the region’s key funding gauge is back near historic lows and is priced to remain there until at least early 2023. In a worst-case scenario where the benchmark surged on defaults, the European Central Bank should respond by adding fallen angels -- companies that have been stripped of their investment-grade credit ratings -- to its asset purchases, according to Pooja Kumra, senior European rates strategist at Toronto-Dominion Bank.

The Bank of England could also be pushed into action on a spike in sterling Libor by stepping up quantitative easing or providing fresh loans to banks on the cheap, according to Athey at Aberdeen. Ditto Japanese markets. Three-month yen Libor is back near its long-term lows and traders are betting on continued stability.

“The government can bail out troubled banks and prevent a surge in short-term borrowing costs,” said Takeshi Minami, an economist at Norinchukin Research Institute Co.

All that means money-market traders the world over are making the same calculation as their bullish stock peers: The bigger the crisis, the bigger the monetary intervention -- even if the risk-taking spurs financial instability down the road.

“Central banks have increased so much liquidity in the financial system and are on stand-by to do more so Libor rates will be contained, bar some seasonal spikes,” said Stoutjesdijk at Robeco.

©2020 Bloomberg L.P.