"In the darkest hole, you'd be well advised
Not to plan my funeral 'fore the body dies, yeah
Come the morning light, it's a see through show
What you may have heard and what you think you know, yeah"
"Grind" | Alice in Chains (1995)
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We thought it might be worth remembering that things in the credit markets were not so great a year ago, when the Federal Open Market Committee started to retreat from its pretense about raising interest rates. In August of last year, dollar LIBOR blew through 2.5% and proceeded to decline until February 2020, when US interest rates fell off the edge of the proverbial table. And thus comes into the focus the great idea of the Fed and other regulators of several years before: Let’s replace LIBOR.
Today dollar rates are starting to edge higher, disappointing those analysts who expected the 10-year Treasury note to test the zero bound prior to the next Treasury refunding. Instead, dollar interest rates seem to be firming ahead of this November’s abortive election scenario. None of the above?
Japan is flat lining as usual and rates in Europe are sinking deeper into negative territory. Many advisors and counsel worry about what happens if the US follows the EU into negative territory. The short answer is that bonds may trade negative yield, but commercial banks and, yes, Federal Reserve Banks and the DTCC can't and won't price negative assets and liabilities. This is Y2K two decades later.
The tightening of Treasury yields is a bit of a surprise given the drop-off in bank lending activity -- at least outside of the overheated residential mortgage sector. In August, the industry will again create well more that $330 billion in new mortgage backed securities (MBS), but markets for non-agency paper remain quiet, that is to say, dead as a doorknob. Polly parrot kinda dead. The carnage caused by the Fed's "go big" strategy in April and May continues to be reckoned in dollars and professional lives destroyed.
Of note, volumes in trading too-be-announced (TBA) and cash MBS coupons continue below the trailing averages. Despite the big issuance numbers, continued Fed purchases of agency MBS is depressing market liquidity. Thus comes the question: What happens when the Treasury starts its next cash raising exercise in a month? How will the market benchmarks react? And are there any benchmarks worthy of the name?
Now conventional market theory holds that when a nation issues more debt into the capital markets, yields should rise in response to the added supply. But in this case we may see the dollar strengthen as foreign demand drives yields down, particularly demand from Japan and the rest of Asia.
The economic context for future market moves will be deflationary, needless to say, owing to the negative impact of COVID19 on spending and credit creation. Robert Eisenbeis of Cumberland Advisors notes in a comment about future inflation that ”the decline in velocity in the short run has offset the money supply increase, due in part to a large increase in precautionary saving and a drastic cut in aggregate demand for many goods and services.” Perhaps the Fed is finally about to find the inflation long sought? Hold that thought.
It is interesting to note, so long as we are focused on market dysfunction, that while many parts of the market are starting the transition from LIBOR to the secured overnight funding rate (SOFR), the bank funded markets for 30-day securities repo and collateral financial markets are not changing. Not even close.
And why is SOFR being shunned by the most important, most conservative MBS market after US Treasuries? Because the banks don't see an alternative to LIBOR for pricing both sides of a 30-day repo trade for MBS and dry FHA guaranteed loans. And for those of us who appreciate that forward TBA contracts for GNMAs are the foundation of the hedging market for Treasury securities, nothing more need be said.
You see, 1 month LIBOR is presently trading around 17bp but there is no comparable 30-day rate in the magical land of SOFR, which is about 9bp for overnight.
The lesson? It was easy for the Washington economists who staff the FOMC to several decades ago confiscate a market benchmark like federal funds. Today, however, its is less easy to create a functioning market rate out of an economic fantasy like SOFR.
Since SOFR is an artificial overnight rate and does not yet have a true market following (aka "markets, people"), including a term structure out even 30 days, warehouse lenders and other providers of cash to the markets are not moving as yet. Memo to Chair Powell: How can a federally insured depository use a nonexistent benchmark like SOFR to price assets and liabilities?
Anyone out there with a term rate structure they don’t need please call Chair Powell at the Federal Reserve Board in Washington. We understand he’s in the market for a slightly used benchmark with an intact secondary market. No questions asked.
It is worth noting that the administration of LIBOR was shifted to the Intercontinental Exchange (ICE) in 2014. In the event that the Federal Reserve is unsuccessful in breathing life into SOFR, as close to a monetary Frankenstein’s Monster as you’ll ever see, we suspect that the Fed may be forced to either (1) fix LIBOR under ICE’s administration or (2) fashion a new indicator based upon the TBA market. Haven't heard that one? Wait for it.
Why not simply fix the existing LIBOR? Well, that would require the folks at the Fed and other central banks to admit that they were wrong to kill the benchmark in the first place. Probably not a good idea. But fashioning a new, functioning market benchmark is not easy.
For one thing, it probably never occurred to the economists at the Fed to base the replacement for LIBOR on a functioning, secured marketplace like TBA. That would require imagination. Stay tuned.