Libor sheds new light on interest rate cuts

--though ECP policy overnight interest rate is 2%, 100 bps higher than BOE's base rate, its effective financial interest rate (Libor rate) is only 15-20 bps higher than BOE's financial interest rates --The root cause is probably because of ECP unlimited liquidity policy using fixed rate tenders, which caused larg volume of cash recycled and deposited acros banks, lowering the LIBORs rates - Eonia. By Paul J Davies Published: February 6 2009 20:28 Last updated: February 6 2009 20:28 The Bank of England took another bold step with interest rates this week making a 50 basis point cut to an historic low of 1 per cent, though even this was not bold enough to match some expectations. The European Central Bank, meanwhile, held rates at 2 per cent, which was expected but not widely welcomed as the sell-off of the euro against sterling illustrated. These moves took the difference between base rates in the UK and eurozone further into unfamiliar territory. However, the interbank lending rates, or Libors, that have become hugely important in judging the health of financial systems tell another story – one that sheds a different light on the ECB’s apparent base-rate sluggishness. EDITOR’S CHOICE Sign of Bank’s new direction - Feb-05Video: Chris Giles on reasons for rate decisions - Feb-05Bank hints more rate cuts to follow - Feb-06Lex: European and UK interest rates - Feb-05Video: John Authers on the euro outlook - Feb-05Lombard: 1694 and all that, redux - Feb-05 Euro Libors have been below sterling Libors since January’s base rate cuts came into effect. As the markets on Friday digested this week’s moves, very short term sterling Libors dropped fractionally below euro Libors once more. But from maturities of two months and outward, euro interbank rates remain below their sterling equivalents. The key to this oddity is in the markets’ overnight interest rates, known as the Sonia for sterling and Eonia for the eurozone. These are the base off which interbank rates take their cue. After the interest rate decisions, the Eonia settled at a level only 18.7bp higher than Sonia – 1.186 per cent versus 0.999 per cent. “The question is: what are the effective rates?” says Laurence Mutkin, analyst at Morgan Stanley. “The difference between the eurozone and UK interest rates really is not 100bp but something more like 20bp. People looking at the official ECB rate alone are failing to take into account the effective overnight rate in the eurozone.” Forecasts support this view, with Bloomberg data showing expectations of a 75bp difference between the two base rates over the rest of this year, but only 17-24bp difference in the euro and sterling three-month Libors. The level of these overnight rates and the interbank rates they lead are the yardstick for whether monetary policy is having an effect on interest rates in the financial system and the broader economy beyond. Some economists and analysts think that the ECB is pursuing a twin-pronged strategy that differentiates between a base rate that is important among the broader population and a financial interest rate that is the real driver of the cost of credit. In January, the ECB widened the difference – known as the corridor – between the base rate and what it pays on cash deposits left with it by eurozone banks. This had the effect of cutting the deposit rate by 100bp when the base rate was cut by only 50bp. At the same time, the central bank is supplying unlimited liquidity through its fixed-rate tenders, which has led to banks drawing down large volumes and recycling the cash as big deposits with the ECB. This in turn has dragged down the Eonia overnight interest rate closer to the deposit rate than the base rate. In the UK, liquidity is also being added, but not in the same unlimited way and the equivalent overnight rate more closely tracks the Bank of England’s base rate. Several analysts welcomed the change in tone this week from Jean-Claude Trichet, the ECB president. His words appeared to increase the chances of a zero interest rate policy. However, this might be closer than the most visible base rate suggests. Mr Mutkin says: “If the ECB continues with the same liquidity policies, and forward Eonias suggest the market view is that it will, then it only needs to cut by 100bp and the effective overnight rate will be in line with where the US Fed funds rate is now.”