Short-term interest rates are the interest rates on loans or debt instruments such as Treasury bills, bank certificates of deposit or commercial paper, that have maturities of less than one year.
Short term interest rate futures (STIR futures) are one of the largest financial markets in the world. The two largest contracts, the Eurodollar and Euribor typically trade in excess of one trillion dollars and euros of US and European interest rates each day. STIR futures are traded on a purely computerized market place. In this guide, we review What Is Short Term Interest Rate, short term interest rates forecast, short term interest rates vs long term, and what is the most widely followed short-term interest rate.
Participants in the interest rate futures market are taking a perspective on the market’s direction — on whether interest rates will climb or fall in the future. Those who wish to protect against increasing rates will prefer to pay a fixed rate and receive a flexible rate in an interest rate swap. Correspondingly, individuals who foresee a drop in rates may desire to receive fixed interest rate payments and pay floating rates. Both parties are hedging against risk. A speculative market also exists for interest rates, consisting of traders seeking opportunities to benefit from interest rate modifications or market volatility.
The Chicago Mercantile Exchange trades the most short-term interest rate futures and options of any exchange, averaging more than 1.6 million contracts daily. The cornerstone of the CME interest rate product line is Eurodollar futures, the world’s most actively traded futures instrument and a benchmark for worldwide investors. The Eurodollar futures give a tool for hedging variations in interest rates on U.S. dollars deposited in overseas banks.
Liffe also offers short-term interest rate instruments, notably its flagship contract suite, the Euribor three-month interest rate contracts, which contain EURIBOR futures, EURIBOR options, and EURIBOR Mid-Curve Options. These products had an average daily volume reaching 1.4 million contracts as of September 2007.
What Is Short Term Interest Rate
If you’re trying to invest money for the short term, you’re probably searching for a safe place to put it before you need to retrieve it in the not-so-distant future. The unpredictable markets and collapsing economy encouraged many investors to keep cash as the COVID-19 problem lingered on — and things remain uncertain as the economy now faces increasing inflation, among other issues.
Short-term investments minimize risk, but at the sacrifice of possibly better profits offered in the greatest long-term investments. As a consequence, you’ll ensure that you have cash when you need it, instead of squandering the money on a possibly unsafe investment. So the most crucial thing investors should be looking for in a short-term investment is safety.
What is a short-term investment?
If you’re making a short-term investment, you’re frequently doing it because you need to have the money at a given period. If you’re saving for a down payment on a house or a wedding, for example, the money must be at the ready. Short-term investments are those you make for less than three years.
If you have a longer time horizon – at least three to five years (and even longer is best) – you can look at assets such as stocks. Stocks provide the potential for substantially larger profits. The stock market has traditionally risen an average of 10 percent annually over extended periods – but it has shown to be highly volatile. So the longer time horizon allows you the ability to ride out the ups and downs of the stock market.
Short-term investments: Safe but poor yield
The safety of short-term investing comes at a cost. You likely won’t be able to earn as much in a short-term investment as you would in a long-term investment. If you invest for the short term, you’ll be confined to specific types of investments and shouldn’t acquire riskier assets such as stocks and stock funds. (But if you can invest for the long term, here’s how to buy equities.)
Short-term investments do have a handful of advantages, however. They’re frequently highly liquid, so you can receive your money whenever you need it. Also, they tend to be smaller risk investments than long-term investments, so you may have little downside or even none at all.
Overview: Top short-term investments in November 2022
Here are a few of the greatest short-term investments to consider that yet offer you some profit.
Overview: A high-yield savings account at a bank or credit union is an excellent alternative to holding cash in a checking account, which normally pays relatively little interest on your deposit. The bank will pay interest in a savings account on a regular basis.
Who are they excellent for? A high-yield savings account works well for risk-averse investors, and especially for those who need money in the short term and want to avoid the danger that they won’t get their money back.
Risks: Savings accounts are covered by the Federal Deposit Insurance Corporation (FDIC) at banks and by the National Credit Union Administration (NCUA) at credit unions, so you won’t lose money.
There’s not really a risk to these accounts in the short term, though investors who store their money over longer periods may have problems keeping up with inflation.
Rewards: You may often earn significantly greater interest rates at internet banks than at traditional, brick-and-mortar banks.
Plus, you can often access the money by rapidly transferring it to your primary bank or maybe even via an ATM.
Liquidity: Savings accounts are highly liquid, and you can add money to the account. Savings accounts normally only allow for up to six fee-free withdrawals or transfers every statement cycle, though. (The Federal Reserve currently permits banks to forgo this rule.)
Of course, you’ll want to watch out for banks that impose fees for maintaining the account or accessing ATMs, so you can limit those.
Where to get them: Savers would do well to comparison-shop high-yield savings accounts, because it’s easy to identify which banks give the highest interest rates and they are quick to set up.
Overview: Corporate bonds are bonds issued by significant corporations to fund their investments. They are normally deemed safe and pay interest at regular periods, perhaps quarterly or twice a year.
Who are they excellent for? Bond funds are useful for investors who desire a diverse portfolio of bonds without having to evaluate individual bonds.
They’re also good for individual investors who don’t have enough money to buy individual bonds, and the risk-averse should like them, too.
Risks: A short-term corporate bond fund is not insured by the government, therefore it can lose money.
However, bonds tend to be pretty safe, especially if you’re buying a broadly diversified portfolio of them.
In addition, a short-term fund provides the least level of risk exposure to changing interest rates, so increasing or decreasing rates won’t effect the price of the fund too much.
Rewards: Bond funds are collections of these corporate bonds from many different companies, frequently across several industries and company sizes.
This diversity ensures that a poorly-performing bond won’t impact the overall return very significantly.
The bond fund will pay interest on a regular basis, often monthly.
Liquidity: A short-term corporate bond fund is very liquid, and it may be bought and traded on any day that the financial markets are open.
Where to obtain them: You can purchase them at nearly any online broker that sells ETF and mutual funds.
Overview: Money market accounts are another sort of bank deposit, and they normally yield a higher interest rate than regular savings accounts, albeit they typically require a higher minimum investment, too.
Who are they excellent for? Money market accounts are useful for those who need their money in the near future and need to be able to access it without any strings attached.
Risks: Be sure to pick a money market account that is FDIC-insured so that your account will be protected from losing money, with coverage up to $250,000 per depositor, per bank.
Like a savings account, the biggest risk for money market accounts develops over time, because their interest rates frequently make it difficult for investors to keep up with inflation.
In the medium term, however, that’s not a huge problem.
Rewards: The major incentive for money market accounts is the interest you can earn on the account, and you’ll also have the opportunity to retrieve the money on short notice if you need it.
Liquidity: Money market accounts are relatively liquid, while federal laws do put some restrictions on withdrawals.
Where to acquire them: You can open money market accounts at numerous banks and credit unions.
Overview: A cash management account allows you to place money in a range of short-term assets, and it operates much like an omnibus account.
Who are they excellent for? A cash management account gives you a liquid cash account that allows you to access your money quickly, and it may pay interest on your assets.
Risks: Cash management accounts are frequently invested in safe low-yield money market funds, so there’s not a lot of danger.
In the case of some robo-advisor accounts, these institutions deposit your money into FDIC-protected partner banks, so you might want to be sure that you don’t exceed FDIC deposit coverage if you currently do business with one of the partner banks.
Rewards: You can typically invest, write checks off the account, transfer money and conduct other standard bank-like operations. So the cash management account allows you a lot of options.
Liquidity: Cash management accounts are extremely liquid, and money can be withdrawn at any time.
In this aspect, they may be even better than standard savings and money market accounts, which limit monthly withdrawals.
Where to get them: Cash management accounts are often offered by robo-advisors and online stock brokers.
Overview: Government bonds are like corporate bonds except that they’re issued by the U.S. federal government and its agencies.
Government bond funds purchase investments such as T-bills, T-bonds, T-notes and mortgage-backed securities from federal entities such as the Government National Mortgage Association (Ginnie Mae) (Ginnie Mae).
Who are they excellent for? Short-term government bonds are suitable for risk-averse individuals who desire a highly safe investment.
Bond funds are useful for investors who desire a diverse portfolio of bonds without having to evaluate individual bonds.
Risks: These bonds are considered low-risk. While bonds issued by the federal government and its agencies are not backed by the FDIC, the bonds are the government’s commitments to return money.
Because they’re backed by the full faith and credit of the United States, these bonds are considered exceedingly safe.
In addition, a fund of short-term bonds means an investor takes on a modest degree of interest rate risk. So rising or falling rates won’t affect the price of the fund’s bonds too much.
Rewards: U.S. government bond funds will pay a dependable rate of interest, albeit because of their safety, they won’t pay as much as corporate bonds.
Liquidity: Government bonds are among the most widely traded securities on the exchanges, hence government bond funds are extremely liquid.
They can be bought and sold on any day that the stock market is open.
Where to obtain them: You can purchase them at nearly any online broker that sells ETF and mutual funds.
Overview: A no-penalty certificate of deposit, or CD, enables you sidestep the normal fee that a bank charges if you cancel your CD before it matures.
CDs are time deposits, meaning when you open one, you’re agreeing to store the money in the account for a specific amount of time, ranging from periods of weeks up to many years, depending on the maturity you want.
In exchange for the security of having this money in its vault, the bank will offer you a higher interest rate.
Who are they excellent for? Those searching for some access to their funds while receiving some income may find the no-penalty CD handy.
A no-penalty CD may also be attractive in a period of rising interest rates, since you can withdraw your money without incurring a fee and then deposit it elsewhere for a larger return.
Risks: CDs are insured by the FDIC, so you won’t lose any money on them. The dangers are minimized for a short-term CD, but one risk is that you may miss out on a better rate elsewhere while your money is locked up in the CD.
The lack of a penalty helps lessen this risk, though. If the interest rate is too low, you may also wind up losing purchasing power to inflation.
Rewards: The bank pays interest on the CD monthly, and at the end of the CD’s term, the bank will refund your principal plus the earned interest.
short term interest rates forecast
Consumer prices in the US rose more than expected in September to 8.2%, a clear sign that inflation woes in the world’s largest economy are far from over.
As policymakers continue their battle with rising inflation, can the US Federal Reserve (Fed) afford to hold off a schedule of rate rises?
With the next Fed meeting overwhelmingly likely to hike rates by 75 basis points on 2 November – the sixth consecutive increase this year – how far can they take it?
What are the projected interest rates in five years, and is there a feasible limit that the Fed will reach?
How do Fed’s interest rates influence the US economy and stock markets?
The Fed’s interest-rate decisions have huge ramifications for the wider global economy, moving markets across equities, bonds, and commodities.
The Fed sets the Federal Funds Rate (FFR), the key base interest rate that filters through to banks, affects demand for bonds and more broadly affects the economy and stocks.
The process starts when the Fed sets the FFR at the Federal Open Market Committee (FOMC) meeting, eight of which occur a year. Those decisions, which have recently resulted in hikes, filter through to prime rate, the basic interest rate banks charge to creditworthy customers.
A hike to the FFR could see the base prime rate rise, affecting the typical cost of a loan and a mortgage. Increasing the cost of servicing loans takes more discretionary income out of consumers and businesses, dampening demand and reigning in price increases.
For stocks, that could mean companies and stocks dependent on consumer spending, such as the retail and hospitality sectors, face headwinds. Growth stocks, which rely on lending and capital, could suffer, too, as investors look for value in profitable companies to ride out market volatility and a downturn.
Mechanically, interest rate rises also hurt the value of bonds. When interest rates rise, the yield on a bond, a fixed-interest debt security previously owned by the investor, becomes less valuable as it garners less interest than the prevailing base rate, forcing a sell-off. This is particularly true for longer-term interest rates, as the discrepancy is magnified over time.
Likewise, fixed-income securities lose their value with rises as the cost of not owning other interest-rate tracking assets increases. Indeed, it means the predicted interest in the next five years could be one of the most telling indicators for markets.
History of the Fed’s interest rate policy
Like other major Western economies, the US has enjoyed an unparalleled period of low price and interest rate volatility. The current bout of price rises means investors could need to reassess how they allocate their portfolios.
The FFR was at a similar rate to where it is now in the 1950s, amid the post-war stimulus and income growth across the US. The rate see-sawed over a 20-year period, rising and falling between 3% and 10% during the 1960s and 1970s, before skyrocketing inflation, exceeding 13% in 1980, forced rates to a still-record high of 19.1%.
As inflation was brought under control, the FFR hovered at 5% through the 90s, before recessions in 2001 and 2008 forced them down to a floor, where they remained until 2016.
The Covid-19 pandemic imposed another rate cut to almost 0%, with recent inflationary pressure created as a result quickly forcing the Fed to begin tightening policy. The most recent was a third consecutive 0.75% hike to a range between 3% and 3.25%.
Past performance is not a reliable indicator of future results
Key factors that could influence interest rates in five years
The Fed is now at the whim of greater market forces as it tries to steady the economic ship, as rising prices and an economic slowdown conspire with supply-chain hold-ups to make the outcome of any policy response uncertain. Inflation, and the chances of a recession, could be top of the list.
How high will inflation go?
The main driver of anxiety in markets, and the key catalyst for central bank action right now, is inflation, which hit a four-decade high of 9.1% in June. The source of inflation is a mix of demand and supply factors, but not always interconnected.
Pent-up demand, particularly for travel, means inadequate supply to supply chains still rattled by Covid-19, while Russia’s invasion of Ukraine, and the ensuing energy insecurity, have ramped up the price of oil and gas.
It means central bankers are unsure how effective monetary tightening will be against several mitigating factors, with rate rises potentially adding more pain without addressing the underlying problem of high prices.
According to the OECD, inflation in the euro area is expected to come down gradually over the next 18 months, hitting 5.5% by the end of this year and falling to 3.9% by the end of 2023.
The Congressional Budget Office (CBO), which advises Congress, has revised its projections upwards. It stated: “As interest rates rise – as they are projected to do in CBO’s economic forecast – federal spending on interest payments, including payments to foreign holders of US debt, would increase substantially.
“More generally, the United States’ fiscal position would be more vulnerable to an increase in interest rates because costs to service the debt rise more for a given increase in interest rates when debt is higher than when it is lower.”
Recession coming to quell the hawks?
The US hit the traditional definition of a recession last week, as it saw a contraction in gross domestic product (GDP) for the second quarter in a row.
While the country is not in an official recession, something which is set by the National Bureau for Economic Research’s (NBER) Business Cycle Dating Committee, it could be a big signal that economic activity is falling and pain could be ahead.
A recession would put pressure on the Fed to halt its regimen of rate hikes to avoid putting further strain on growth, with analysts only needing to look at the direction of travel for rates during previous recessions.
But interest rate predictions linked to a recession depend on the response from the government to any recession. Joe Biden has been seen to dish out huge fiscal stimulus in times of hardship since taking the presidency, while some states have rolled out stimulus cheques to help citizens battle the rising cost of living.
And the spectre of stagflation, which is beginning to affect the US economy, could make policymakers’ decisions even more difficult.
Projected interest rates in 5 years
Analysts typically focus their gaze on the near term, with ‘long-term’ interest-rate forecasts stretching into next year and over the next 10 FOMC meetings. Still, they provide insight into interest-rate forecasts over five years.
In a note from Barclays shared with Capital.com, analysts Joseph Abate and Jonathan Millar said interest-rate movements over the next year could be volatile and depended on the level of bank reserves through its schedule of quantitative tightening (QT), the process of taking liquidity and demand out of the market.
Abate and Millar noted that the level of QT could dry up reserves by the year-end, forcing banks to take action.
While not providing an interest-rate forecast, the analysts thought rates might begin to contract next year.
In its latest monthly budget review, the CBO expected the Fed to stick to its targeted interest rate area and avoid going to exorbitant levels, commenting: “Inflation has recently reached its fastest pace in four decades. It is expected to remain high in 2022 because of various factors that continue to restrain supply in the face of strong demand in product and labour markets. Inflation slows in 2023 and 2024 in CBO’s projections, nearing the Federal Reserve’s long-run goal of 2% by the end of 2024.”
short term interest rates vs long term
Interest Rates and Duration
An important concept for understanding interest rate risk in bonds is that bond prices are inversely related to interest rates. When interest rates go up, bond prices go down, and vice versa.
There are two primary reasons why long-term bonds are subject to greater interest rate risk than short-term bonds:
Do Long-Term Bonds Have A Greater Interest Rate Risk Than Short-Term Bonds?
How Interest Rate Risk Impacts Bonds
Interest rate risk arises when the absolute level of interest rates fluctuates. Interest rate risk directly affects the values of fixed income securities. Since interest rates and bond prices are inversely related, the risk associated with a rise in interest rates causes bond prices to fall and vice versa.
Interest rate risk affects the prices of bonds, and all bondholders face this type of risk. As mentioned above, it’s important to remember that as interest rates rise, bond prices fall. When interest rates rise, and new bonds with higher yields than older securities are issued in the market, investors tend to purchase the new bond issues to take advantage of the higher yields.
For this reason, the older bonds based on the previous level of interest rate have less value, so investors and traders sell their old bonds, and the prices of those decrease.
Conversely, when interest rates fall, bond prices tend to rise. When interest rates fall, and new bonds with lower yields than older fixed-income securities are issued in the market, investors are less likely to purchase new issues. Hence, the older bonds with higher yields tend to increase in price.
For example, assume the Federal Open Market Committee (FOMC) meeting is next Wednesday, and many traders and investors fear interest rates will rise within the next year. After the FOMC meeting, the committee decides to raise interest rates in three months. Therefore, the prices of bonds decrease because new bonds are issued at higher yields in three months.
During the FOMC meeting on March 15-16, 2022, the Fed increased interest rates due to rising inflation. The target range was increased by .25% (or 25 basis points) for the first time since 2018. The target range went from 0% to .25% to .25% to .50%.
How Investors Can Reduce Interest Rate Risk
Investors can reduce or hedge, interest rate risk with forward contracts, interest rate swaps, and futures. Investors may desire reduced interest rate risk to reduce the uncertainty of changing rates affecting the value of their investments. This risk is greater for investors in bonds, real estate investment trusts (REITs), and other stocks in which dividends make up a healthy portion of cash flows.
Primarily, investors are concerned about interest rate risk when they are worried about inflationary pressures, excessive government spending, or an unstable currency. All of these factors have the ability to lead to higher inflation, which results in higher interest rates. Higher interest rates are particularly deleterious for fixed income, as the cash flows erode in value.
Forward contracts are agreements between two parties, with one party paying the other to lock in an interest rate for an extended period of time. This is a prudent move when interest rates are favorable. Of course, an adverse effect is the company cannot take advantage of further declines in interest rates. An example of this is homeowners taking advantage of low-interest rates by refinancing their mortgages. Others may switch from adjustable-rate mortgages to fixed-rate mortgages as well. Futures are similar to forward contracts, except they are standardized and listed on regulated exchanges. This makes the arrangement more expensive, though there’s less chance of one party failing to meet obligations. This is the most liquid option for investors.
Interest rate swaps are another common agreement between two parties in which they agree to pay each other the difference between fixed interest rates and floating interest rates. Basically, one party takes on the interest rate risk and is compensated for doing so. Other interest rate derivatives that are employed are options and forward rate agreements (FRAs). All of these contracts provide interest rate risk protection by gaining in value when bond prices fall.
The Bottom Line
Investors holding long term bonds are subject to a greater degree of interest rate risk than those holding shorter term bonds. This means that if interest rates change by 1%, long term bonds will see a greater change to their price—rising when rates fall and falling when rates rise. Explained by their greater duration measure, interest rate risk is often not a big deal for those holding bonds until maturity. For those who are more active traders, hedging strategies may be employed to reduce the effect of changing interest rates on bond portfolios.
what is the most widely followed short-term interest rate
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
LIBOR, which stands for London Interbank Offered Rate, serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks. The rate is calculated and will continue to be published each day by the Intercontinental Exchange (ICE), but due to recent scandals and questions around its validity as a benchmark rate, it is being phased out.
According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates are no longer published as of Dec. 31, 2021.
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
London Interbank Offered Rate (LIBOR)
Understanding LIBOR
LIBOR is the average interest rate at which major global banks borrow from one another. It is based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves seven different maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
The combination of five currencies and seven maturities leads to a total of 35 different LIBOR rates calculated and reported each business day. The most commonly quoted rate is the three-month U.S. dollar rate, usually referred to as the current LIBOR rate.
Each day, ICE asks major global banks how much they would charge other banks for short-term loans. The association takes out the highest and lowest figures, then calculates the average from the remaining numbers. This is known as the trimmed average. This rate is posted each morning as the daily rate, so it’s not a static figure. Once the rates for each maturity and currency are calculated and finalized, they are announced and published once a day at around 11:55 a.m. London time by the ICE Benchmark Administration (IBA).
LIBOR is also the basis for consumer loans in countries around the world, so it impacts consumers just as much as it does financial institutions. The interest rates on various credit products such as credit cards, car loans, and adjustable-rate mortgages fluctuate based on the interbank rate. This change in rate helps determine the ease of borrowing between banks and consumers.
But there is a downside to using the LIBOR rate. Even though lower borrowing costs may be attractive to consumers, it does also affect the returns on certain securities. Some mutual funds may be attached to LIBOR, so their yields may drop as LIBOR fluctuates.
How Is LIBOR Calculated?
The IBA has constituted a designated panel of global banks for each currency and tenor pair. For example, 16 major banks, including Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS constitute the panel for U.S. dollar LIBOR. Only those banks that have a significant role in the London market are considered eligible for membership on the ICE LIBOR panel, and the selection process is held annually.
In April 2018, the IBA submitted a new proposal to strengthen the LIBOR calculation methodology. It suggested using a standardized, transaction-based, data-driven, layered method called the Waterfall Methodology for determining LIBOR.
The Waterfall Methodology retains the trimmed average calculation.
The IBA calculates the LIBOR rate using a trimmed mean approach applied to all the responses received. Trimmed mean is a method of averaging, which eliminates a small specified percentage of the largest and smallest values before calculating the mean. For LIBOR, figures in the highest and lowest quartile are thrown out, and averaging is performed on the remaining numbers.
Uses of LIBOR
LIBOR is used worldwide in a wide variety of financial products. They include the following:
LIBOR is also used as a standard gauge of market expectation for interest rates finalized by central banks. It accounts for the liquidity premiums for various instruments traded in the money markets, as well as an indicator of the health of the overall banking system. A lot of derivative products are created, launched, and traded in reference to LIBOR. LIBOR is also used as a reference rate for other standard processes like clearing, price discovery, and product valuation.
A Brief History of LIBOR
The need for a uniform measure of interest rates across financial institutions became necessary as the market for interest rate-based products began evolving during the 1980s. The British Bankers’ Association (BBA)—which represented the banking and financial services industry—set up BBA interest-settlement rates in 1984. Further streamlining led to the evolution of BBA LIBOR in 1986, which became the default standard interest rate for transacting in the interest rate- and currency-based financial dealings between financial institutions at the local and international levels.
Since then, LIBOR has undergone many changes. The major one is when BBA LIBOR changed to ICE LIBOR in February 2014 after the Intercontinental Exchange took over the administration.
Currencies involved in calculating LIBOR have also changed. While new currency rates have been added, many have been removed or integrated following the introduction of the euro rates. The 2008 financial crisis saw a significant decline in the number of tenors for which LIBOR was calculated.
Alternatives to LIBOR
Though LIBOR was once accepted globally, there are other several other interest rates that are popularly followed across the globe.
For instance, Europe has the European Interbank Offered Rate (EURIBOR), Japan has the Tokyo Interbank Offered Rate (TIBOR), China has Shanghai Interbank Offered Rate (SHIBOR), and India has the Mumbai Interbank Offered Rate (MIBOR).
LIBOR Scandal of Rate Rigging
While LIBOR has been a long-established global benchmark standard for interest rates, it has had its fair share of controversies including a major scandal of rate rigging.
Major banks allegedly colluded to manipulate the LIBOR rates. They took traders’ requests into account and submitted artificially low LIBOR rates to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up traders’ profits who were holding positions in LIBOR-based financial securities.
Following reporting by the Wall Street Journal in 2008, major global banks, which were on the panels and contributed to the LIBOR determination process, faced regulatory scrutiny. It involved investigations by the U.S. Department of Justice. Similar investigations were launched in other parts of the globe including in the U.K. and Europe.
Major banks and financial institutions including Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS, and Deutsche Bank faced heavy fines. Punitive actions were also taken on their employees who were found to be involved in the malpractice. The scandal was also one of the primary reasons why LIBOR shifted from BBA administration to ICE.
Benefits of Watching LIBOR Rates
Despite the rate-setting scandals, LIBOR rates provide a useful benchmark for the level of activity in the global economy. A falling LIBOR indicates that it is becoming easier to borrow money, possibly forecasting an increase in economic activity. A rising LIBOR means that it is getting harder to borrow money, meaning business activity is likely to slow down.
These rates are particularly significant to a prospective borrower. When you borrow money from a bank, LIBOR rates may account for part of your interest rate. A high LIBOR means that you may have to pay a higher interest rate on your mortgage or personal loan, while a low LIBOR means a more favorable rate.
Special Considerations: Phasing Out LIBOR
Although LIBOR has been used since the 1980s, regulatory reforms have begun in recent years to reform benchmark rates and ultimately replace LIBOR as the interbank borrowing rate. U.K. banks are no longer required to publish LIBOR rates after 2021.
The new system is designed to replace the conjecture surrounding interest rates that was predominant under LIBOR and instead use actual transaction rates. The secured overnight financing rate (SOFR) will replace LIBOR in 2023. The SOFR is also a benchmark interest rate used for dollar-denominated loans and derivative contracts. SOFR is different than LIBOR in that it’s based on actual observed transactions in the U.S. Treasury market while LIBOR used estimations of borrowing rates.
However, SOFR is likely to be used in the U.S. and the U.K. but other countries are exploring using their own version of a benchmark rate for when LIBOR is phased out.