Flipped! LIBOR Below Funds

Economic data are likely to get much worse before they get better given the tendency for momentum in the economy to be self-feeding. Any improvement in the outlook is likely to be presaged by financial signals such as those contained in LIBOR and financial conditions more generally.

LIBOR has been plunging since the year began, which in addition to signaling reduced strain in the financial system will have real effects by reducing funding costs for households and firms.

For example, it is known that many mortgages are tied to LIBOR, which means that the reset problem won't be as great as was feared just a few weeks ago. Adding to the improving picture is the expected decline in the prime rate, to which many debts are tied, including home-equity loans, commercial and industrial loans, and credit cards.

Today, for the first time since June 2003, which was the month in which the Fed delivered the last of its rate cuts for the 2001-2003 rate-cut cycle, three-month dollar-based LIBOR is trading below the fed funds rate by 20 basis points.

The inversion is of course related to expectations for a 50-basis-point rate cut at or before the Fed's upcoming meeting, but the decline is nonetheless important because it represents both a continuation of the recent trend toward a narrower spread to fed funds and a drop in outright costs to debtors.

LIBOR in currencies other than the U.S. dollar have also trended favorably of late. For example, sterling-based three-month LIBOR is today at just 17 basis points over the Bank of England's benchmark rate, very close to "normal" levels, and well below the 115-basis-point spread seen last August.

Keep in mind as well that commercial paper rates have fallen, also signaling reduced funding pressures and a decrease in the cost of capital. For example, 30-day asset-backed commercial-paper rates today are at 4.13%, down substantially from the roughly 6% rates that prevailed at the end of December. The spread below fed funds is unusual most times, and, hence, remarkable considering the recent environment.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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