Explaining the SIBOR Plunge

What’s new?

3-month SIBOR has held at about 1.8% for the third consecutive day, dropping about 60bp from the 2.375% prevailing at the start of the year. Similarly, long rates have also fallen, with the 10Y bond yield dropping from 2.68% to 2.35% in the same period, and the yield curve has flattened slightly with the 10Y-3M spread declining from 95bp in mid-December to 70bp currently. The decline in SIBOR appears counter-intuitive, particularly when the central bank has embarked on a tighter monetary policy stance in its semi-annual October-07 review. Also, inflation has yet to peak and seem likely to track around 6% in 1H08, in our view.

Explaining the SIBOR decline

We believe that the movement in SIBOR could be reflecting the central bank’s challenge in managing the different corners of the ‘impossible trinity’. Under the impossible trinity framework, monetary policy makers – in an open economy – have to decide which of the other two corners of the ‘impossible trinity’ (i.e. exchange rate or interest rate) it wants to retain control over. Monetary policy makers in Singapore have traditionally chosen to have tighter control on the exchange rate rather than interest rate. This means that domestic interest rates such as SIBOR are determined by global interest rates, currency expectations and MAS sterilization operations.

It appears now that MAS is letting liquidity drive down the SIBOR rates. Though this is slightly counter-intuitive, given that inflation has yet to peak, we believe that there are several reasons that could explain the SIBOR plunge:

1) Fed futures pricing: On the back of weaker US data such as manufacturing ISM & payrolls and Bernanke’s speech overnight, which was more dovish than expected, Fed futures have (since the start of this year) began to price in more aggressive Fed ease, just about fully pricing in a cut to 3% at the June meeting. This is lower than our US economists, Richard Berner and David Greenlaw’s, expectation of 3.5% by 2Q08. Additionally, Fed futures are now pricing in an 88% chance of 50bp cut at the January 30-31 meeting, compared to the 25bp cut they were pricing in at end-December 2007.

2) Currency appreciation: A confluence of factors is contributing to SGD appreciation pressures. As we mentioned previously, rate cuts in the US and more cuts to come are threatening to put pressure on US$ weakness. Also, as of now, still relatively dichotomous economic momentum between the developed economies such as US, which are at the epicentre of the credit crunch, and economies such as Singapore, which are at the periphery of the credit problem but would be impacted via trade and financial market linkages spillover, are leading to a weak US$ and still strong flows into Singapore. Liquidity inflows, as measured by the FX accretion, have picked up in recent months. Dec-07 12-month and 3-month FX accretion now stand at 10.4% and 13.5% of GDP, respectively. Additionally, a more marked currency appreciation in other Asian currencies such as RMB and rumours of more to come amid inflationary pressures have also increased S$NEER appreciation pressures. As a result, the trade-weighted SG$NEER, which is managed within a policy bandwidth, continues to test the boundaries, tracking at the upper policy band.

3) Uncovered interest rate parity (UIRP) rule: With the SG$NEER testing the upper boundaries, given liquidity flows, MAS needs to sell SGD and buy USD to prevent the S$NEER from overshooting the upper band. This will inject liquidity into the system. MAS can accelerate its sterilization operations to absorb the liquidity which will hold SIBOR rates up. However, as a part of these flows are likely less stable in nature, we believe that MAS has allowed liquidity to drive down interest rates to reduce the returns on the currency and ease appreciation pressures on the SG$NEER.

Facing a policy dilemma

Indeed, the need to manage SG$NEER within its boundaries meant letting go of the third corner of the ‘impossible trinity’ and allowing SIBOR to be driven down by liquidity. This SIBOR plunge is not without precedent (see Asia Pacific Economics: US$1 Trillion Excess Liquidity Tide – Triggering Policy Surprises? May 10, 2007). Recall that in 1H07, excess liquidity triggered policy shifts in several Asian countries. SIBOR also declined from 3.4% as at February 2007 to a low of 2.3% by May 2007 amid the liquidity tide as the SG$NEER was tracking persistently near/at the upper band. Inflation was not a concern back then. However, the SIBOR decline now poses a policy dilemma, given that inflation is running at its highest level since the exchange rate policy was adopted in 1981, the oil shock years of 1980s notwithstanding. Going forward, inflation likely has more to run and could go closer to 6% in 1H08 amid the 18-25% revision of the public housing annual values (see Singapore: Revision of HDB Annual Values: A Better Reflection of Cost-Push Pressures in the Economy, November 13, 2007), the lagged impact from property reflation, high capacity utilization, transport fare revision, electricity tariffs revision and food & oil prices.

Where will SIBOR go next?

We estimate where SIBOR could go based on the UIRP framework, which suggests that the difference between global and domestic interest rates is equal to expected currency appreciation (see equation below).

iUS – iSingapore =Expected Appreciation of SG$ against the US$

Where iUS = US interest rate & iSingapore = Singapore interest rate

In our base case, our fed funds target rate (FFTR) expectations and SGD currency futures at this point are implying that SIBOR would back up to 2.5% by end-2008 as global growth rebounds in 2H08 and the US Federal Reserve starts raising rates in 4Q08. However, there are several moving parts to our SIBOR forecasts, and risks to our forecasts would arise from changes in expectations regarding the US economic outlook and Fed easing, as well as the pace of appreciation of other Asian currencies. All things being equal, risks to our FFTR forecasts and hence our SIBOR forecasts could be to the downside, particularly in light of Bernanke’s speech overnight.

By Deyi Tan, Morgan Stanley
January 11, 2008