USD: Ultra-low Libor must rise

Libor will live out its final days in market centres through 2021, but it is strutting through 2020 with quite a bit of attitude. One of the issues with Libor is the implied bank risk that it contains, which proved exceptionally volatile during crises (most notably through the great financial one). But as we head towards the end of 2020, Libor is on the floor. USD Libor at 20bp is some 5bp below the Fed funds ceiling - not much implied bank credit risk there. Libor is trading like a premium product here, sitting adjacent to risk-free rates.

The likelihood in 2021 is that this changes. We think that USD Libor should be some 10bp higher than it is currently, and we'd assert similar for Ibors in most other centres. For example and remarkably, 3mth Euribor is currently flat to the ultra-safe ECB's deposit rate. While this can be rationalised on account of advantageous bank funding conditions, it still looks anomalous. The low valuation attached to Libor is reflective of a lack of systemic stresses, which is a good thing. And by extension, there is an implied positivity imputed on the banking system. This is a valid point of positivity, but the question is whether it can persist.

So while central banks may not do an awful lot in 2021 in terms of policy changes, we would expect to see Ibor rates drift higher from current levels. An important ancillary rationale here centres on the likelihood that risk attributed to banks and the system ratchet higher again, especially as default risk gets re-elevated.

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