“In no sense, is this QE…” Federal Reserve Chairman Jerome Powell

Federal Reserve Chairman Jerome Powell gave a speech on Tuesday, October 8, that touched upon recent events in the repo market. We discuss below certain aspects of this speech in the context of the market discussion regarding the replacement of U.S. dollar LIBOR with SOFR – the Secured Overnight Financing Rate in USD. USD LIBOR is at the heart of the interest rate world and its replacement is a once in a generation challenge.

SOFR is a rate published by the Federal Reserve Bank of New York (the “New York Fed”) based upon secured overnight transactions in the repo market. It is of increasing importance, since it has been regarded by many market participants as the basis for the likely successor to U.S. dollar LIBOR, a long-standing benchmark which is being phased out at the behest of the U.K.’s Financial Conduct Authority.

A recent confluence of events exposed insufficient elasticity in the USD overnight cash repo market which contributed to a cash/liquidity crunch on September 17, 2019, that we refer to as the “SOFR Surge Event”, in which the SOFR rate spiked (or surged) by 282 basis points, compared with the previous day. The liquidity shortfall was met with robust technical countermeasures by the New York Fed, the result of which was to re-stabilize SOFR in the period after September 17.

The speech by Federal Reserve Chairman Jerome Powell on Tuesday October 8 clarified:

  1. the SOFR Surge Event was a technical issue that can be readily addressed by the Federal Reserve [“We will not hesitate to conduct temporary operations if needed to foster trading in the federal funds market at rates within the target range”]
  2. current and planned liquidity actions by the Federal Reserve (e.g., purchasing Treasuries) would be for reserve management purposes and were not quantitative easing [“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis”]

The contemplated expansion of the Federal Reserve’s balance sheet is a discretionary matter relating to the control of the money supply and has the effect of adding cash/liquidity to the repo market. In circumstances where the Federal Reserve is taking material steps to “foster trading” “within the target range”, free market forces are dampened. In contrast, in an unmanaged market, the repo interest rates would rise to the extent necessary to create liquidity in the market.

Near to medium term issues regarding primary dealer excess inventories of Treasuries is an area of focus by the Federal Reserve, as well as the underlying causes; e.g., supply conditions for primary dealers arising from a variety of trading conditions, including the vital carry trade, and viable paths for mitigating excess inventories and ameliorating the underlying causes. The effectiveness of the Federal Reserve in addressing these issues will be essential to avoiding adverse spillover effects to the corporate credit and high yield cash market (both in USD and other currencies).

SOFR is, in large measure, impacted by the Federal Reserve’s stabilization activity. We query whether SOFR might more fairly be characterized, in these conditions, as a government-managed rate that is subject to discretionary adjustment by the Federal Reserve, an arm of the government that has a wide-ranging mandate and acts as both the lender of last resort and protector of the USD as a reserve currency. This agenda may very well not correlate with SOFR as a representative risk free rate.

We previously commented[1] on the notable differences in rates that the SOFR Surge Event produced, especially compared to LIBOR which remained stable and was not volatile over the same period. The effects of this volatility in SOFR will be impactful during the applicable look-back period, since SOFR is calculated on a look-back basis (as opposed to a forward-looking basis, which is the case with LIBOR). The rates on the day of the SOFR Surge Event will form a calculable component of SOFR for a fixed period (i.e., until the SOFR Surge Event is no longer included in the relevant look-back period). The Alternative Reference Rate Committee, which oversees SOFR, contextualized the impact of the SOFR Surge Event in a communication on September 18: “The volatility in overnight SOFR is clearly visible, but it also can be seen to have had negligible impact on the averages of SOFR. The second chart clearly demonstrates that the point made in the ARRC’s Second Report remains true: a 3-month average of SOFR is less volatile than 3-month LIBOR. For example, although SOFR rose sharply yesterday due to special factors related to tax payments and Treasury issuances, a 3-month average of SOFR only rose 2 basis points relative to the week before those fluctuations, while 3-month LIBOR rose 4 basis points.” We note that this comparison does not address the forward impact of the SOFR Surge Event and it may be helpful to market participants to run the same analytics after the SOFR Surge Event exits the calculable period for SOFR.

Assuming that SOFR will replace LIBOR, we note the following considerations for credit market participants when considering the post-replacement interest rate environment: (1) if the Federal Reserve’s rate management activity has the effect of reducing SOFR, it has the risk of reducing the returns to lenders (and potentially providing a windfall to borrowers) if SOFR does not then adequately reflect such lender’s cost of funding; and (2) there is the potential benefit for periods of managed stability, as well as the risk of volatility, as the Federal Reserve implements the management of repo interest rates.