By Richard Leong
NEW YORK (Reuters) - Interest rates for banks to borrow U.S. dollars for three months are likely to rise further before topping out near 1.0 percent, unless the Federal Reserve raises interest rates by year-end, market watchers say.
The jump in three-month London U.S. dollar interbank offered rates (Libor), a benchmark for more than $300 trillion worth of securities around the globe, has stemmed from moves in the $2.7 trillion U.S. money market fund industry to sidestep new regulations that take effect on October 14.
Libor rates of various maturities have reached their highest in more than seven years recently as banks are seeing a drop in demand from money market funds for their U.S. dollar-denominated commercial paper and certificates of deposits.
Shrinking demand for bank debt among prime money funds is a result of some funds choosing to own only U.S. Treasury and other government-related securities in an effort to be exempt from new rules from the U.S. Securities and Exchange Commission before the October 14 deadline.
"The bulk of move has already taken place and that was a calendar effect when three-month Libor moves into October," said Kevin Kennedy, portfolio manager at Western Asset Management Co. in New York. "Eventually you will see Libor level off a bit."
On Wednesday, three-month U.S. dollar Libor rate held at 0.82544 percent, its highest since May 2009.
The contract expiring in December for eurodollar futures, which track expectations for Libor rates in the future, currently imply the rate will be around 0.91 percent by year end.
About $500 billion worth of prime money fund assets have already switched to government securities since late last year and another $400 billion is forecast to convert in coming weeks.
These asset flows have driven up borrowing costs for banks and companies that issue floating-rate debt whose interest rates adjust to changes in Libor.
"That's going to have an impact on bank margins. I think the markets are deep enough to absorb it but absorb it at wider spreads,” said Mike Swell, co-head of global portfolio management of fixed income at Goldman Sachs Asset Management in New York.
Many analysts believe Libor’s rise will wane once the conversion of prime money funds to government-only funds is over.
Others think this grind higher in rates could deter the Federal Reserve from raising its policy interest rate at its September meeting.
Pending regulations on money funds from the Securities and Exchange Commission are the final group of reforms aimed to safeguard the industry that saw heavy redemptions following the collapse of Lehman Brothers in September 2008.
Under the new regulations, the unit value of money market funds will float, rather than being guaranteed at $1, and funds may impose fees on withdrawals to control the massive redemptions as seen during the global credit crisis in 2008.
These new SEC rules are disliked by institutional investors because they undermine the image of money funds as a near substitute for regular bank accounts.
SCRAMBLE FOR DOLLARS
Overseas banks, especially Japanese ones, have paid up to get their hands on U.S. dollars since July as fewer prime funds have purchased their debt.
Foreign banks are paying investors higher interest rates on their commercial paper and certificates of deposits than three-month Libor. Two months earlier, they were paying close or below Libor, analysts said.
"The prime funds' supply of relatively low-cost funding for these foreign banks has fundamentally changed and has changed permanently," said Brandon Swensen, co-head of fixed income with RBC Global Asset Management in Minneapolis.
Another sign of the jump in costs for foreign banks to raise U.S. dollars is seen in currency markets.
The cost premium on one-year cross-currency swap contracts, measured by the one-year dollar Libor, over the one-year rate on yen, was quoted about minus 71.50 basis points on Wednesday, ICAP data showed.
This premium for players to exchange yen-denominated payments for dollar-pegged payments eased from the steepest level since Oct 2008 reached last week.
Banks and hedge funds use these swaps for currency bets, while U.S. companies use them to hedge their non-dollar denominated bonds.
FED RATE HIKE LURKS
The direction of Libor rates may also be complicated by the possibility the Federal Reserve may raise interest rates by the end of the year, analysts said.
Some analysts argued the recent rise in Libor was enough to cover the risk of a federal funds rate hike.
The Fed's current target on the fed funds rate, or what banks charge each other to borrow excess reserves, is 0.25-0.50 percent.
"The absolute level of Libor is a function of bank credit cost and expected fed funds," said Alex Roever, head of U.S. interest rate strategy at J.P. Morgan Securities in New York.
On Wednesday, federal funds rates futures implied traders saw an even chance the Fed would raise it policy rate at its Dec. 13-14 policy meeting, according to CME Group's FedWatch program.
On Sunday, Fed Vice Chairman Stanley Fischer gave a mostly upbeat view on the U.S. economy, supporting the notion the central bank is preparing for a rate increase.
"If the Fed actually hikes, then this will obviously have to be priced into higher Libor as well," said Praveen Korapaty, head of U.S. rates strategy at Credit Suisse in New York.
(Reporting by Richard Leong; Editing by Dan Burns)