LIBOR does not follow the Fed

The monetary policy response to the credit crisis has been to lower the Fed funds rate. The monetary channel for increasing credit is to lower rates to cheapen the costs of banks to lend longer-term. A steep curve is a license to print money for most financial institutions. There is only one problem with this scenario, higher risks associated with banks themselves and the risk of lending. If lending is considered riskier, then the rate on LIBOR will increase. This increase in risk premium may be greater than what stimulus the Fed provides.

There also is a strong desire for window dressing at the end of this year. Who wants to hold risky assets at the turn of the year? This is why we currently see one-month LIBOR at 5.25% and yet one-year LIBOR is at 4.43%, an 80 basis point difference. Now if credit is cut-off over the turn of the year, there will have to be liquidation of assets from balance sheets which will lead to depressed prices for end of year price marks. There could be some wild fluctuation of prices with December 31, on a Monday. This end of the year financial zaniness may not be controlled by the Fed regardless of what they do over the next four weeks.