Damaged credit market machinery leads to a “new normal” for lending rates
Friday, 22 August 2008
Before August 2007 the relationship of 3 month LIBOR to base rate was largely determined by the market's view on the future course of base rate. The market would discount anticipated changes by the MPC and 3 month LIBOR would trade either above or below the current level of base rate. Spreads tended to be quite narrow and, for counterparties with a reasonably high short term rating (A1 or P1), there was a good level of liquidity and the market worked efficiently.
Since August 9th 2007 and the full onslaught of the 'credit crunch', the position has changed dramatically. Money market liquidity has plunged and in general terms the market has become inefficient. The old model, whereby market rates anticipated the future course of base rates, has been overwhelmed by a model where a lack of liquidity and the growth of counterparty risk dominates. This has resulted in market rates, for all but the shortest of maturities, trading significantly above base rate even when base rates are expected to fall. This premium (of between 70-100 basis points) is now an established part of the money market and has persisted despite ever more aggressive intervention by the Bank of England to ease the position.
It is clear that there is a huge amount of stress in the money market, leading Moody's to comment recently that there are "extreme short-term systemic pressures on the banking system in the UK."
In rough terms we have seen two periods of 'crisis' LIBOR rates in the last year: one in August/September 2007 and one in December 2007 followed by a rally in January/February. A third wave began in March and the feeling now is that premiums of up to 100 basis points over base rate represent a "new normal", reflecting a world where capital is in short supply relative to demand.
Base rate was reduced to 5% in April and has been left unchanged since then. Our view is that we expect the base rate to remain on hold at 5% before falling. We believe that although CPI may go as high as 5% in the near future it will fall back quickly as the economy slows. The MPC can do little to influence inflation in the short term but will be forced to cut rates as the economy falls towards recession in the second half of the year. The economy's credit machinery is badly damaged and there is a risk of a negative feedback loop developing to perpetuate the problem. Indeed, such a loop has already begun in the housing market, with tighter credit conditions leading to falling prices, pushing banks to tighten their credit conditions further and so on.
While we believe that current market rates offer good value against a base rate of 5% we remain vigilant to the deteriorating economic background and the pressures this places on the banks we lend to. At a time like this, investing in a diversified basket of high quality, highly rated counterparties is the most prudent approach.
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For further information please contact:
RLAM
Stephen Watchorn
Tel: 020 7506 6582
Stephen.watchorn@rlam.co.uk
Quill Communications
Jo Stonier
Tel: 020 7758 2230
Jo.s@quillcommunicate.com
Editor's notes:
Royal London Group
, is a specialist financial service provider. Its businesses focus on those sectors of the market which value quality propositions, operating through a number of brands:
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Scottish Life – UK pensions market
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Bright Grey – UK protection market
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Scottish Provident – UK protection market
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Phoenix Life Assurance Limited – provides life and pensions products to Abbey's national branch network
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Scottish Life International – offshore investment markets
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Scottish Provident International – offshore investment markets
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RLAM – fund management
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RLCM – specialist cash and liquidity management for UK onshore clients
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RLAM C.I. – specialist cash and liquidity management for offshore clients
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RLAS – life and pensions administration
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Fundsdirect / Ascentric – funds supermarket; Wrap platform
Royal London is the largest mutual life and pensions company in the UK with Group funds under management of £32.4 billion. Group businesses serve around three million customers and employ 2,750 people. Figures quoted are as at 30 June 2008, prior to the acquisition of Scottish Provident's new business capabilities (in respect of individual life protection business) and of Phoenix Life Assurance Limited.