The primary economic themes have changed very little in recent months. On the data front, concerns over recent weakness in core inflation readings continue to weigh on long-end yields and market inflation expectations. More specifically, monthly core consumer price index (CPI) growth for June came in below expectations for the fourth consecutive period. The year-over-year core rate held steady at 1.7%, which is down 60 basis points (bps) from the January reading and the lowest in more than two years. On a positive note, owners’ equivalent rent (OER) rose 0.3% in June; the largest gain since December. OER is a significant contributor to the core CPI calculation, and it has run below expectations for much of 2017.
Federal Reserve leaders have been largely dismissive of concerns that the inflation trend is anything but transitory, although small cracks in that assessment are beginning to emerge. In her testimony before the House Financial Services Committee on July 12, Fed Chair Janet Yellen remained confident that “temporary factors appear to be at work” regarding recent inflation weakness, but she acknowledged some concern about risks to that assessment. Additionally, in the July 26 statement, the FOMC removed the caveat “somewhat” from its language regarding the inflation trend, noting that overall and core inflation measures “have declined somewhat and are running below 2%.” This subtle, but not insignificant, change suggests there is a growing debate within the committee on the inflation front.
With the healthcare reform effort all but dead, focus now shifts to tax reform, which was arguably the most eagerly anticipated legislative item post-election by the financial markets (particularly equity markets). Presumably, the tax reform debate should be less contentious than healthcare, but it also depends on Republicans’ ability to get on the same page. Recent articles suggest that White House officials (including the President) are more engaged in this effort and are motivated to get a significant legislative victory on the board, particularly with the 2018 mid-term election cycle looming. However, getting something done in 2017 will be difficult, given the pending budget negotiations. President Trump has long called for a reduction in the corporate tax rate to 15%, but the White House has reportedly backed off that goal and is now targeting something in the 20-25% range. Some House Republicans, including the House Freedom Caucus, have complained that too much of the negotiations are occurring in secret, so GOP leaders have a tough challenge ahead.
U.S. Debt Ceiling
Another near-term headwind for the financial markets is the pending debate on raising the debt ceiling, which is currently set at $20 trillion. The Treasury Department has been using so-called extraordinary measures to meet current obligations, but those measures are expected to be fully exhausted in October. Given the current level of political animus, market participants aren’t expecting a quiet or seamless process, but most understand that an agreement eventually will be reached. In the end, most politicians don’t want to go down in history as responsible in any way for a government shutdown, and certainly not a U.S. default on its debt. That said, there definitely could be some heightened volatility. If you look back to the 2011 debt ceiling debate, there was a significant reaction in the market. As Exhibit 1 illustrates, from July 27, 2011 to August 10, 2011, Treasury yields fell 7 bps to 87 bps, with intermediate and long-end yields experiencing the most dramatic decline. The S&P 500 fell 14%, and implied volatility in both equities and fixed-income markets surged higher. Amid that debt ceiling uncertainty, Standard & Poor’s downgraded the U.S. credit rating for the first time ever. Despite the ratings action, Treasury yields continued to fall (and the dollar appreciated). To be fair, there were other concerns that contributed to the global flight-to-quality trade, most notably the ongoing European debt crisis. Market participants today aren’t necessarily expecting a repeat of 2011, but it’s the most recent example of the implications of any potential government shutdown and subsequent U.S. default. There should be ample amounts of political posturing in the coming weeks but, presumably, both parties would not want such a major negative event to drive next year’s mid-term elections in either direction.
On July 27, U.K. Financial Conduct Authority (FCA) chief Andrew Bailey made headlines when he announced during a speech that the FCA’s intent to phase out LIBOR by the end of 2021. To be clear, this action has been in the works for quite some time, so it wasn’t a major surprise for active participants in interest-rate (rates) markets. LIBOR was created in 1986 as a benchmark for short-term interbank lending rates and, over the years, it’s become the most popular benchmark used for trillions of dollars of financial assets, including interest-rate swaps and floating-rate loans/securities (currently tied to approximately $350 trillion of securities and derivatives). However, in the post-crisis financial markets, the interbank lending market that LIBOR is supposed to represent shrunk dramatically. Given the lack of observable inputs, LIBOR panel banks had to rely on “expert judgement,” as Mr. Bailey referred to it in his speech, in determining the daily rates for each tenor. Given these fundamental limitations, the FCA and other world policymakers have been working on solutions for an alternative benchmark.
In the United States, the Alternative Reference Rates Committee (ARRC) was established in 2014 under Federal Reserve Board sponsorship with the goal of creating a LIBOR alternative that was based on actual market transactions. After more than two years of work, the ARRC announced on June 22 that it recommended the Broad Treasuries Financing Rate (BTFR) as the alternative to LIBOR as a reference rate benchmark. The BTFR is a secured rate comprised of Treasury repo trades, which includes general collateral (GC) tri-party and cleared bilateral by the Fixed Income Clearing Corporation FICC), and actions would be taken to exclude “specials” repo transactions (i.e., non-GC). From a transactional volume perspective, these repo trades represent average volume of $660 billion per day, as contrasted with LIBOR-eligible transactions of less than $15 billion year to date. Therefore, the depth, liquidity, and transparency of the Treasury repo market achieves the ARRC’s primary objective in that regard.
Many steps must be taken for full implementation of this process, which is why Bailey suggested a 4-5 year timeframe for guidance, and establishing a deadline is the only way to achieve progress toward the goal. To start, the Fed and Treasury Department’s Office of Financial Research plans to begin publishing the rate in the first half of 2018. Once daily rate publishing commences, the Chicago Mercantile Exchange (CME) announced plans to launch repo-backed futures and options, pending regulatory approval. This is a necessary step in building market depth/liquidity for the new benchmark rate. The next area of focus will be an amendment to credit support annexes (CSA) within ISDA agreements for swaps to reflect the new discount rate.
In the near-term, there shouldn’t be a significant impact on interest-rate swap (IRS) markets, but there will likely be a migration from LIBOR to effective Fed funds for the underlying floating rate, the latter of which is a closer approximation of the new repo benchmark. For large financial institutions hedging debt issuance and other liabilities, this migration had already begun in response to heightened volatility in in the LIBOR-OIS spread (fed funds is the floating leg of OIS).
The third major step will likely be changing the reference rates for end-users of consumer loans. This ties in with another major question for market participants when deciphering the ultimate impact on floating-rate securities tied to LIBOR. While there are still more questions than answers at this point, it’s important to note that both Freddie Mac and Fannie Mae have language in the general offering circulars (OS) and servicing guides that set guidelines for this situation for both single-family and multi-family securities. As an example, the following language can be found in the Freddie Mac OS for multiclass certificates (covers CMO floaters):
“If the BBA no longer sets an Interest Settlement Rate, we will designate an alternative index that has performed, or that we expect to perform, in a manner substantially similar to the BBA’s Interest Settlement Rate. We will select an alternative index only if tax counsel advises us that the alternative index will not cause any affected REMIC Pools to lose their classification as REMICs.”
Regulators understand the challenges of such a major initiative, but almost everyone agrees it must eventually happen. The process has to start somewhere, and Bailey acknowledged the magnitude of this effort. At the same time, he said the amount of disruption “depends on the preparations that users of LIBOR make in either switching contracts from the current basis for LIBOR or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition.”
This doesn’t mean that there won’t be pockets of volatility in the coming years, but ALM First strongly discourages alarmist or reactionary responses in the near term, particularly as it relates to selling assets. There almost certainly will be opportunists who are compensated on a transactional basis that sensationalize the story and prop “bond swaps” as a solution. In many cases, the investor ends up recognizing the worst-case scenario via wider bid-ask spreads. This will be a long process, and it affects the entirety of the financial markets. Therefore, no investors are unique in their concerns, and more answers will derive as we move further along in this migration.
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