Published on October 14 2016

Forget The Fed…Here’s the Key Interest Rate You Need to Be Watching

Interest rates are skyrocketing.

You might think that’s a typo. After all, the Federal Reserve hasn’t lifted its key interest rate once this year. The Bank of England just cut its key rate to a record low. And the European Central Bank and Bank of Japan are using negative interest rates.

These “benchmarks” set the tone for interest rates across the global economy. If they aren’t rising, how could other rates be rising?

Believe it or not, there’s another key interest rate most people have never heard of…and it’s arguably more important than the Fed’s key interest rate.

We’re talking about the London Interbank Offered Rate, or “Libor.”

Libor is the rate banks use when they lend money to each other over short periods of time. According to Bloomberg Markets, $7 trillion worth of debt is tied to Libor, including mortgages, student loans, and corporate bonds.

When Libor rises, other interest rates do, too.

• Libor has jumped from 0.61% at the start of the year to 0.88% today…

That’s a staggering 44% rise in less than 10 months. You can see Libor’s dramatic spike in the chart below.

Libor hasn’t made a move like this since 2008. And it’s now at the highest level since 2009.

• Many analysts think new government regulations caused Libor to spike…

You see, a series of new market reforms took effect today.

The changes are aimed at money market funds, which invest in short-term securities, liquid debt, and monetary instruments. Bloomberg Markets reported on Tuesday:

The new rules require prime money market funds — an important source of short-term funding for banks and companies — to build up liquidity buffers, install redemption gates, and use 'floating' net asset values instead of a fixed $1-per-share price. While the changes are aimed at reinforcing a $2.7 trillion industry that exacerbated the financial crisis, they are also causing turmoil in money markets as big banks adjust to the new reality of a shrinking pool of available funding.

According to Bloomberg Markets, investors moved money out of money market funds before the changes went into effect:

Some $1 trillion worth of assets have shifted from prime money market funds into government money market funds that invest in safer assets such as short-term U.S. debt, according to Bloomberg estimates. The exodus has driven up Libor rates as banks and other corporate entities compete to replace the lost funding.

Today may have been the deadline for these reforms, but that doesn’t mean Libor will stop surging…

• You see, Libor isn’t just an important interest rate…

It also measures stress in the banking system. The more stress banks are under, the higher the Libor rate.

You can see in the chart below that Libor shot through the roof when Lehman Brothers filed for bankruptcy in September 2008.

At the time, the banking system was in a state of panic. Banks didn’t know if other banks were sound or sitting on a mountain of toxic loans. Because there was so much uncertainty, banks charged each other very high interest rates.

Eventually, Libor fell back down to earth…but only after the Fed announced a massive “stimulus” program.

• To be clear, we aren’t saying the U.S. banking system is about to implode…

But there are definitely reasons to be worried about the U.S. banking system right now.

For one, U.S. corporations are defaulting at the fastest rate since 2008. And the net interest margin for major U.S. banks is at the lowest level in decades. (Net interest margin is a key measure of bank profitability.)

If these problems persist, Libor could keep climbing.

• Rising interest rates aren’t necessarily a bad thing…

If you own bonds, higher rates could put more money in your pocket.

At the same time, rising rates could create serious problems for borrowers. After all, debt becomes more expensive when rates climb. And that’s not something many companies can afford right now…

Since 2010, U.S. corporations have borrowed almost $9 trillion in the bond market. That’s 50% more than U.S. corporations borrowed in the seven years leading up to the financial crisis.

This epic borrowing binge wouldn’t be so concerning if the economy was doing well. But the U.S. economy is growing at the slowest rate since World War II.

• Corporate profits haven’t kept up with the huge surge in borrowing…

Earnings for companies in the S&P 500 have actually been falling since 2014.

This has created a very dangerous situation. The Wall Street Journal reported yesterday:

Median debt at junk-rated companies is five times earnings before interest, taxes, depreciation and amortization, or Ebitda, according to Moody’s data. That compares with 4.2 times in 2008. The debt ratio for investment-grade companies is 2.6 times Ebitda, compared with 2.2 times in 2009, Moody’s data show. In other words, corporate balance sheets are far weaker than they were before the last financial crisis…which will make it hard for many companies to “stomach” higher rates.

• Libor’s recent jump has already caused borrowing costs to rise…

Bloomberg Markets reported last month:

A benchmark for near-term borrowing, the three-month U.S. dollar London interbank offered rate, has risen above 0.75 percentage point. That’s a key threshold for junk-rated companies with about $230 billion of loans outstanding according to data compiled by Bloomberg — with Libor above that level, the borrowers will have to pay more interest over time. The increase so far could amount to about an extra $230 million of total interest expense annually for the companies.

Remember, Libor is already at 0.88% and rising fast…

The next critical level to watch is 1.00%. According to Bloomberg Markets, more than $900 billion worth of leveraged loans are benchmarked at this level. If Libor rises above this level, this debt will be subject to higher rates, too.

Some analysts think that could happen soon. Bloomberg Markets reported on Tuesday:

TD Securities speculate that Libor will “head higher” and the spreads won't “compress anytime soon.” Meanwhile, Goldman Sachs Group Inc. thinks Libor will reach a 3.6 percent by the end of 2019 — or about 270 basis points more than its current level.

• The average investor isn’t prepared for a major credit crisis…

He thinks the Fed still has everything under control. That’s a dangerous assumption…

As you’ve seen today, rates can rise whether the Fed wants them to or not. Unfortunately, it will be too late by the time most people realize this.

That’s why we encourage you to take action today.

You can start by setting aside cash, owning physical gold, and shorting (betting against) weak stocks.

If you’ve never shorted a stock, read this new interview with E.B. Tucker, editor of The Casey Report. It explains everything you need to know about shorting, including what to look for when shorting a stock.

We also encourage you to read this essay by E.B. As you’ll see, Libor’s recent spike is just the latest sign that the credit market is “drying up.” If this continues, we could soon have a full-blown global economic crisis on our hands.

In his eye-opening essay, E.B. explains how to prepare and even profit from this coming collapse. We encourage you to share this essay with your family members and friends. It’s one of the most important warnings that we’ve ever published. Click here to see why.

Chart of the Day

The Fed is all bark and no bite…

If you’ve been reading the Dispatch, you know the Fed is talking about raising its key interest rate right now. You probably also know that the Fed’s been saying the same thing all year. 

You can see below that the Fed originally planned four hikes for this year. Then it said it was going to raise rates twice. But it hasn’t pulled the trigger once this year.

In March, it didn’t raise rates because of a bad jobs report. In June, it held off due to concerns about the global economy and “market volatility.” Last month, it didn’t raise rates because it’s waiting for the job market to improve.

At this point, the Fed has no credibility. Yet the market is still “pricing in” a rate hike because the Fed’s talked one up. That’s a big reason why the price of gold is down 5% over the past month.

You see, gold doesn’t pay interest like a bond. Because of this, many investors don’t like to own gold if they expect rates to rise. Of course, regular readers know the conventional wisdom about gold and interest rates is dead wrong.

As we pointed out last month, the price of gold has actually increased after the last four Fed rate hikes.

Louis James, editor of International Speculator, isn’t sweating gold’s recent selloff either. He actually thinks it could turn out to be an incredible buying opportunity. Louis wrote on Monday: 

I do see the current correction as healthy. When gold or silver companies can rise 400% before they even return to profitability, you know the market has gotten ahead of itself.

I do see this needed correction as a buying opportunity. I also think the data will show that Asian buyers of physical gold see it this way as well. It’s particularly encouraging to see strong growth in the Indian economy, even as the year-end wedding season gets underway.

In other words, there are plenty of reasons to still own gold and gold stocks. So, don’t throw in the towel just because the Fed is talking about raising rates. 

Regards,

Justin Spittler
Delray Beach, Florida
October 14, 2016

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