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SOFR Swoon - High Quality Credit Spreads

FICC Podcasts October 20, 2021
FICC Podcasts October 20, 2021

 

Dan Krieter and Dan Belton discuss the unexpected dip in the overnight SOFR rate including its drivers and implications for investors. Other topics include recent factors impacting credit markets, developments in the LIBOR/SOFR transition, and SOFR swaps.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello, and welcome to Macro Horizon's high-quality spreads to the week of October 20th. SOFR Swoon, I'm your host Dan Krieter here with Dan Belton. As today, we update our view on credit, given the move higher, and Treasury yields in the past week, and spend the majority of the podcast today talking about the unforeseen two basis point drop in SOFR, and what it may mean going forward for the front end, and for credit markets.

Dan Belton:

Each week we offer a view on credit spreads, ranging from the highest quality sectors such as agencies and SSAS to investment grade corporates. We also focus on USD swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or email directly at Dan dot Krieter. K-R-I-E-T-E-R@bmo.com. We value and greatly appreciate your input.

Speaker 3:

The views expressed here are those are the participants, and not those of BMO capital markets, it's affiliates or subsidiaries.

Dan Krieter:

Well, then I think the number one market narrative in the weeks, since our last podcast has clearly been the move in Treasury yields, particularly at the foot end of the curve, which has been accompanied by another round of flattening in the Treasury yield curve, and from a credit perspective, I guess we really haven't seen much.

Dan Belton:

No, we haven't. We're pretty range-bound in credit still, despite this sell off and Treasury yields really across the curve. But you said, led by really great hike expectations, we're now pricing to about six rate hikes between 2022 and 2024. So pricing in a much more aggressive path for Fed action due largely to the continued high prints and inflation with respect to credit. Like I said, not much going on, we've rallied a few basis points over the past week, mostly on the back of stronger than expected earnings, but credit spread indices right now are really in the middle of this range that we've been in for the better part of the last six months or so.

Dan Krieter:

Yeah, we have seen a bit of narrowing to your point. I think that was pretty much all at the end of last week, as earnings reports started to roll in. It's really been no movement at all so far this week. And actually what strikes me as most surprising is we haven't really seen any change in the spread curve shape. And I think that's a little surprising in the context of the move in Treasury yields. We typically see a positive correlation there and really spread curves haven't moved at all despite the flattening and Treasury. It's just been kind of a whole lot of nothing in spread so far. And I think for me, the question is, will that continue? Obviously you talked about the pull forward of rate high expectations, and that is definitely not a positive for credit. Also we've seen breakevens moving higher near the decade plus long highs here.

Dan Krieter:

So looking at deepening inflationary concerns, which also not a good thing for credit and still spreads holding in. I think a lot of it has to do with earnings from a high level. We only have what 10% of earnings reported so far, but some major ones have come in and you know, they're good, not great, not a whole lot to be said. You can poke holes in a few of their earnings reports where revenue gains are coming from things of that nature. But it seems like from a high level, the biggest takeaway from earnings is its sort of a breath of relief, right? That we could have been a lot worse in Q3 that the proliferation of the Delta variant and it doesn't seem to have had a major impact at least so far. So I think that's keeping spreads. Range-bound now at the narrow end of the range. My question is how long look continue.

Dan Belton:

Yes, so with respect of earnings. If you look at, for instance, the Citi Economic Surprise Index, that's about as low as it's been since the onset of the pandemic, which says to me that there was a lot more downside risk with respect to corporate earnings this quarter so far that hasn't been realized by enlarge. And so I think there's a little bit of reason for a slight relief rally, but like you said, earnings good, not great, not too much to focus on here, at least through just about the 10% of earnings or so that we've seen to this point.

Dan Krieter:

Maybe we can just leave it here even for this week with spreads unchanged. I don't really see much change to our view that we laid out last week. If you miss last week's episode, I think it's a good one to go back to. We sort of set the foundation for our medium term view on credit, which suggests that the next significant move in credit will likely be wider to a higher trading range in 2022, maybe not a significantly higher trading range, but we expect as accommodation from both the fiscal and monetary side wanes here to see credit just sort of drift higher into a little bit wider over range in 2022.

Dan Krieter:

So we still, I think I speak for both of us here, remain in the camp that taking advantage of risk on days with spreads really only four or five basis points off cyclical lows here, any risk on days with spread performance is a good opportunity to maybe sell, take some profits and look forward to reestablishing carry trades. So at the end of this year into next year, what we expect will be slightly wider spreads. I mean, are we in a generally in agreement there Dan?

Dan Belton:

Yes, I think we're going to continue to trade in this range for the foreseeable future. At least until we get some clarity about the path of inflation and Fed policy.

Dan Krieter:

We can maybe leave it there on credit for today and transition to our main topic of the day, which I think was really solidified for us this morning when we got a surprising drop in SOFR yesterday. SOFR rate dropped from five basis points to three basis points, as we've all seen now. The first time it's printed below five basis points since June leaving a lot of market participants to sort of scratch their head at why we saw a full two basis point drop in SOFR today, I'll kick it to you, Dan what's driving this?

Dan Belton:

So I think there's a couple of things we can point to. First, it's important to keep in mind this backdrop that we've had for the better part of the past year, which is that we've had excess supply of cash and a lack of collateral on the front end of the system. This has been due largely to Fed QE and also more recently the debt ceiling, which has reduced the supply of collateral in the repo market. Now more recently, as we saw this move higher in Treasury yields, this has resulted in more Treasury securities, trading special and repo.

Dan Belton:

Now, for those of you who aren't as familiar with the repo market, when certain Treasuries trade special and repo they're lent at a lower rate than GC or general collateral, which can drag down the average repo rate. Now SOFR as a volume weighted median repo rate, which attempts to control for the impact of specials by cutting out the bottom 25% of all transactions. Now that 25% is probably more than any amount of specials that trades in a given day. But if the amount trading special is more on a given day, it simply drags down the median rate of repo. And that could be partially to blame for this reduction in SOFR.

Dan Krieter:

Yes, I mean backing up a little bit here. I think what will likely bear the brunt of the blame for this is likely to be GSE cash. We are now in the quote on quote float period where GSEs are putting more cash into the front end, after they've received mortgage payments from their mortgagees and have yet to send the cash out to the investors. There is a couple day window here where there's just more cash invented in the front end here from the GSEs. We are in that window. Now that is going to be putting downward pressure on repo for sure. That's sorted yesterday, really, and that's going to be blamed and that is likely playing a role here, but I don't think that is the only contributing factor here. In fact, if you look at just SOFR percentile seeing where the first of the 25th percentile is so far has printed since the beginning of October, we've seen this consistent March downward.

Dan Krieter:

It's not just one day GSE cash is in the market heavier than normal and boom. So for three basis points, it has been this sort of decline gradually in the past couple of weeks where the headline numbers stayed at five, but we've seen the underlying metrics exhibiting more evidence of downward pressure. And then you sort of have the 800 pound grill in front of the GSE cash, kind of jump on the pile and maybe that's sufficient to push it through five, but it's not just GSE cash, something else is going on, Dan. And I think you are right that it has to do with the volatility to the front end of the curve. First, you talked about the impact of specials. That certainly makes sense. We're going to see more specialists, more collateral is shorted given the pretty rapid move wider in short spreads here. And that's going to mathematically pull down the SOFR average rate.

Dan Krieter:

And then there's also an argument to made here that there are a lot of counterparties that aren't eligible to park their cash at the Fed via the RRP that maybe are looking for more shelter at the short end of the curve. I mean, if you're a portfolio that's constrained to buying say within three years or even five years, and you've seen the incredibly fast repricing at the short end of the curve, you may be looking at just parking your cash and repo, for a day or two here or a week. And wait until you see Treasury yield stabilize before dipping your toes back in. So we could be seeing just in addition to the impact of specials, more cash that's ineligibly put at the Fed, that's looking for a home in the repo market and driving the rate down that way. So I think you have the confluence of those two factors.

Dan Krieter:

And then some of the longer term factors you talked about that is all sort of culminated with the SOFR swoon, if you will, a bit of a play on words there, the opposite of a SOFR spike. To three basis points today. Now I think we've covered what are likely the drivers of it. Maybe more importantly though, is what does this mean? Going forward, I'll start here. Dan, is this move sustainable?

Dan Belton:

So I think that once this GSE cash leaves the system, will probably move back towards the Fed's RRP rate of five basis points, but it is certainly possible that next month when GSE cash re-enters the system, we get some more downward pressure and we trade below the bottom of the range. And I think that's the important thing to take away here is that the Fed's tool of the RRP rate is clearly leaky with respect to SOFR. SOFR can trade below the Fed's RRP rate, which it hasn't done before today. And so that has a lot of implications for money market investors, including those investing in FRN indexes to SOFR, which are now receiving a fairly significant rate, three basis points versus five basis points. And it's not totally clear how long this is going to last, or whether SOFR can go back down the low RRP, assuming it moves back to five basis points in the next few days.

Dan Krieter:

Yes. I'm in broad agreement with you. I think this will likely prove to be an aberration. The floor should hold more often than not. And once that GSE cash will clean out and we get some more stability at the front end, you see specials come down, you see people maybe more comfortable moving out the maturity spectrum a little bit. We'll probably be back to five basis points in short order here. So long-term ramifications like for the Fed, I see basically nothing. I don't think the Fed cares much. The floor is mostly working and we're this to continue somehow for a prolonged period of time, they would just deliver another technical adjustment. I don't think we're anywhere near that now, but they could do that if they needed to. And the Fed's not going to be very concerned with this, I don't think.

Dan Krieter:

The longer term ramifications for me is, like you said, on the investor front, this is just another, maybe mark against SOFR here, particularly for FRN investors who five basis points to three basis points doesn't sound like much, but that's 40% of your base rate. And the drivers we talked about, well, we expect it to go back to five in short order here, they are durable to a certain extent. It could be that specials remain elevated and there's still way more demand at the front of the curve to keep repo down here and keep SOFR at three basis points for a period of a couple of weeks.

Dan Krieter:

We don't think that's what's going to happen, but it is possible. This isn't just GSE cash. And so if you're FRN investor and now all of a sudden, the fourth from the RP is maybe more leaky than we thought. And this is a possibility, this is something that could happen that the new rate is so exposed to these technical factors that you could get, like in September 2019, a big spike or today an unexpected drop beneath the Fed's floor. That's just going to be another criticism of the rate that maybe isn't loved already by FRN investors. So it's something to keep an eye on, but I think we can broaden the conversation out here to some more transition related topics, but I don't know what that means. So there's really not any other options. SOFR is the only rate that is used in FRNs at this point.

Dan Belton:

Yes, that's right. There were a few FRNs index to Bisbee, but that enthusiasm has waned in the past few months. And now it's really just SOFR.

Dan Krieter:

Yes, we had 40 billion in SOFR in September, averaging around 30 billion per month now, so for FRNs, maybe there's not much to take away, but as we look forward to the next few weeks and months, like we're entering a very critical period here for LIBOR transition now. Whereby the end of the year, all financial contracts are scheduled to be moved over off of LIBOR. And we can provide a bit of an update there, I pulled the numbers for a conference just this week and still outside of the FRN market, all cash and derivative markets outside of FRN, still utilize LIBOR extremely heavily. We can start just with derivatives. Won't be a surprise to anybody, but LIBOR continues to greatly overshadow SOFR. SOFR volumes are like 15 to 20% of LIBOR volumes in derivative space now. And that's up significantly since July, when inter-dealer conventions transitioned from LIBOR to SOFR.

Dan Krieter:

And we have another maybe quote on quote watershed event here coming Friday, where the LIBOR screens are now turned off on the inter-dealer market. So maybe that's another inflection point where we see SOFR volumes picking up again, but still LIBOR remains the rate of choice in derivative markets. And that's certainly true in cash markets as well, outside of FRNs, looking at loans still LIBOR is the overwhelming selection for most use rate now. We have seen some loans index to both Bisbee and SOFR, but I think we're talking about what, like 10 to 15 loans in SOFR and maybe 15 to 20 in Bisbee with the volumes much larger in SOFR. I think we're at about upwards of 15 billion in SOFR and around five or less in Bisbee. So still extremely low loan production on anything but LIBOR and that's going to change soon. And so where the conversation from another potential criticism of SOFR here in this three basis point drop where that may be entered into the calculus most is what rate is going to be chosen by loan market participants in the months ahead.

Dan Belton:

Yes, so I think what's interesting about SOFR loans is the few that have been originated at this point, all reference overnight SOFR currently, and that's likely to change just with time. Loan market participants have been instructed to use term SOFR and given that CME's official term SOFR is a relatively recent development and the licensing and other factors that need to take place before that can be used more widely are just going to take time. I think that's also likely to change, as you mentioned in the derivative market. It takes time for these new rates to catch on, but I would expect that in the coming weeks and months, we see a pretty sharp uptake in SOFR products.

Dan Krieter:

Yes, term SOFR is going to be a game changer, but there's not all that time left, as you say. And there's still is significant interest on the loan side, in non-SOFR rates from particularly regional banks down to community banks. SOFR just isn't necessarily a rate that works for them or they don't think it does at least not now. And so there is still a lot of interest in Bisbee and Ameribor even some interest in Prime. And we know that loans are being actively marketed with Bisbee and other non-SOFR rates and well LIBOR remains the rate of choice. That's going to change soon. And we're going to finally start to find out which rate is going to become the de facto rate. And as we've said for a long time, now it's not going to be just one. Probably all of these rates are here to stay now.

Dan Krieter:

I can't imagine that any of them are going to go away and it's going to be this market trying to adapt all at once to whatever the loan side decides. And this drop in SOFR, maybe some loan offices that haven't determined what rate they're going to use yet. I can't imagine it helps them move more towards SOFR. It's still the waiting game. We still don't know anything yet, but we know that the [inaudible 00:15:28] side is going to have to quickly adapt to whatever rate is chosen by the cash side. And to that point, Dan, I thought it might be worth a couple minutes here talking about what is a swap spread now that LIBOR swap spreads are sort of on the decline.

Dan Krieter:

We're going to be talking about SOFR swap spreads now, and they have entirely different drivers than, you know, the sort of historical factors that we'd look at driving LIBOR swap spreads. We're going to have to start thinking about things in terms of SOFR swap spreads now. At least if an, until Bisbee swaps or other rates swaps grow in importance, it's going to be SOFR swaps. And we're going to start thinking about what those drivers are. And I know you took a look at this recently for our written work. What did you find?

Dan Belton:

Yes, so like you mentioned, SOFR swab volumes are currently about 20% of LIBOR swap volumes and that's increasing pretty rapidly and we're expecting more of an increase on Friday. Once the CFTC guidance that inter dealer brokers turn off LIBOR screens takes effect. But obviously because SOFR is unsecured overnight rate, whereas LIBOR is term and unsecured. The SOFR swap spread curve is entirely below the LIBOR swap spread curve and is actually completely negative. So, SOFR swap rate across the curve is lower than a match maturity Treasury. So if we're comparing a SOFR swap, spread to a LIBOR swap spread, that curve is going to be entirely negative and below this LIBOR swap spread curve. So on one hand we have a lot of similar factors driving SOFR swap spreads, as we do with LIBOR swap spreads. So for instance, the Treasury leg of each swap spread is largely the same factors like primary dealer positions, foreign demand for Treasuries and other things that impact the costs and demand for holding Treasuries are going to be largely the same.

Dan Belton:

But on the other hand, instead of being driven by factors impacting unsecured funding and financial market stress. SOFR swap spreads are driven more by repo rates. So a couple of the factors that we found that are interesting and important in our swap spread model are things like assets and government money market funds. So as government money market funds hold more assets that represents an influx of cash into the repo system, which drives down repo rates and narrows SOFR swap spreads, we also have similar technical factors that also drive LIBOR swap spreads like hedging demand. And that's only going to increase as SOFR swap volumes continue to increase. So even though SOFR swaps can't be used to hedge credit risk, there's still likely going to be used by asset swappers. Once LIBOR goes away in order to hedge interest rate risk. And we're seeing that more and more as this year end 2021 deadline approaches. We're expecting another increase in that shortly.

Dan Krieter:

Yes, so a lot to unpack there, Dan, but I think one of the things that stood out to me is who's going to use SOFR swaps and it's going to be the same people that use LIBOR swaps. We're going to see duration accounts using swaps to get duration depending on it's attractiveness versus Treasuries. We're going to see assets harbors continue to use sulfur swaps to mitigate interest rate risk, even if it does nothing to mitigate credit risk. And I guess as we wrap up here that mitigation of credit risk is still a key outstanding question for me, as we continue to march towards the end of LIBOR and more importantly, the end of LIBOR in any financial contracts, what is going to be used to hedge credit now, or is the answer nothing?

Dan Krieter:

And if the answer is nothing, are we going to see loan books that benchmark versus SOFR having to build in a bit of a wider spread, if it's Bisbee versus 2.50, are we going to need SOFR plus 2.60 to sort of compensate for over the life of that asset, the potential for an increase in cost of funds for a bank, and how is that going to be received by loan borrowers?

Dan Krieter:

Is it going to drive them towards Bisbee? They see the headline risks we've all talked about. Now, this sticker shock, if you will, of seeing a higher spread attached to SOFR than would be for another credit sensitive rate, or are we going to see the market continue to adapt with potentially using CDS? That's been talked about a lot using credit default swaps as a way to hedge credit risks now. It's hard to believe that's going to be a broad based solution for many people that just given liquidity and sophistication challenges around the CDX market. It's just something we've talked about for years now. And it doesn't feel to me like there's yet an answer. And now as we get closer to the end of the year, it's still for me, one of the biggest wildcards surrounding LIBOR transition is what's going to happen without the ability to hedge credit risk in derivative markets.

Dan Belton:

Yes, Dan. That's really the one aspect of the transition that I think has not been addressed adequately. And surprisingly, it hasn't been talked about as much as I would have thought that it would be, especially now in the fourth quarter of 2021, really on the Eve of this mandated move away from LIBOR. It's very surprising to me that we don't have any real solution to this problem.

Dan Krieter:

Yes, we saw the enthusiasm for Bisbee really fall off the cliff alongside, well, two things really. First, the regulators came up pretty sharply with criticism of it all in that coordinated day in the summer. But also we got term SOFR and that seemed to really quiet a lot of the drum beat for Bisbee or other credit sensitive rates. Now we at least have a term rate. We can deal with it, but there's still no answer to the credit spread problem. And I guess I'm on talking about here's the problem without potential solutions, but that is just how unknown it is now. And it could have real ramifications that we're not adequately seeing now because it's hard to even handicap what the impact of that is going to be.

Dan Krieter:

So I guess this is just another conversation about LIBOR reform. We've certainly talked about it a lot in this podcast in months and years past, it's been a while, because there's not much new to report as we continue to wait to see what direction the loan side goes and how derivative markets develop, but we're really on the Eve of it, like you said, and there's still various significant, outstanding questions that we're going to find out the answer to for better or for worse here within the next few months.

Dan Krieter:

And with that, Dan, I don't have much else to talk about today. Do you have anything else before we sign off?

Dan Belton:

No, I think that covers it. Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons, please visit us at B-M-O-C-M.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible. We'd love to hear what you thought of today's episode. Please email us at Daniel dot Belton, B-E-L-T-O-N@bemo.com. You can listen to this show and subscribe on Apple podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including a FIC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:

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Speaker 3:

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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD

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