Freddie’s Move to SOFR Got You Rattled? Relax.
Last Week: Interest rates ended the week about where they started, as equities traded higher. The yield on the benchmark US 10-year Treasury note dipped two basis points to 1.57%, after plumbing the lower end of its recent range earlier in the week, while 1-month LIBOR rose 1 basis point to 1.66%. A flight-to-quality move ahead of the three-day weekend drove the widely watched spread between 2- and 10-year Treasury yields to the flattest level since November. Meanwhile, the price of a barrel of oil rose $1.35 to $52.00, as the US Dollar and Gold both strengthened. Treasury yield volatility – a big influencer on the cost of interest rate caps and swaptions – fell to 4.27% from 4.58% a week ago.
Fed Chair Powell: Negative rates won’t come to a theater near you anytime soon. With the Fed likely on hold for the foreseeable future, Chair Jerome Powell testified on Capitol Hill last week, stating that with the economy growing at a moderate pace, the Fed’s “on hold” stance remains appropriate, although it’s on the lookout for negative economic spillovers from the coronavirus. Household fundamentals remain solid, he said, but noted that business investment and exports have been weak due to trade developments and sluggish foreign growth. Powell dismissed the use of negative interest rates, testifying that they would hurt bank profitability and limit credit expansion. Like his predecessors, the Fed chair called on Congress to reduce the nation’s fiscal deficit. While the Fed Chair’s testimony was right on script, he did say something that caught our attention that you may have missed…read on.
For all of you freaking out over Freddie Mac’s announcement that it won’t be accepting LIBOR-based loan applications after September 30th, RELAX. We expect the transition to SOFR (or whatever the final floating index is) ultimately to be a smooth one and to have little impact on floating rate borrowers and lenders at the end of the day. We’d also like to remind you that details of the transition – including which floating rate index lenders will choose to use – is still in flux. One can see this in Fed Chair Powell’s testimony to Congress last week. When asked whether Congress should “simply give the Fed the right to prescribe backup rates when debt instruments do not do so,” or explicitly adopt SOFR, Powell responded that the Fed will inform Congress if a change in federal law is needed, emphasizing that the Fed’s “process is ongoing” and that it is “committed to having the banks ready at the end of next year to switch…away from LIBOR in case [the rate] is no longer published.” Powell noted that while SOFR will be the main substitute for LIBOR, the Fed is “working with regional [banks] and some of the larger banks, too, about the idea of also having a [non-SOFR] credit sensitive rate.” Want to know more? We’ll cover the topic extensively in our upcoming DL Report publication, set for release later this week.
Surge in new coronavirus cases means rates will stay low for even longer. Chinese officials changed their criteria for determining who is considered a coronavirus patient, creating a surge in newly reported cases. With many factories in China idled for an extended period and supply chains significantly disrupted, China is taking both monetary and fiscal steps to cushion the economic blow caused by the outbreak, which is expected to be severe but temporary. Noteworthy economists expect Chinese Q1 GDP to fall to 4.5%, down from 6% last quarter. For the US economy, the virus impact is TBD, although the latest data on ever-important consumer sentiment and small business attitudes suggest that lower energy prices may be having a bigger impact than virus concerns for now. In the meantime, investors overseeing trillions of dollars are plowing money into US government debt like never before, in a wave that’s only gaining strength as the spreading coronavirus casts greater doubt on the global growth outlook. It’s a trend that will keep a lid on any significant, upward move in interest rates.
Mixed bag of US economic data dooms rates to their recent ranges. Data releases last week on industrial production, consumer sentiment and retail sales painted a fuzzy picture on the health of the US economy, helping to keep investors on guard against a downturn, and rates lower as a result. For industrial production, factory activity was mixed at best across various industrial sectors, with aircraft and parts production falling a whopping 10.7% due to Boeing’s 737 Max woes, subtracting 0.3 percentage points from overall industrial output, which posted a 0.3% decline in the month. Capacity utilization in US factories fell to the lowest reading since September 2017, showing that business capex remains almost non-existent despite the recent claims in US-China trade tensions. For consumer sentiment, it’s registering near its all-time peak seen in March 2018. The vast divergence between business capex and consumer sentiment means that CEOs aren’t nearly as optimistic about the future as employees. While the coronavirus could pose downside risks to consumer sentiment in the future, for now the exact opposite is occurring as households respond favorably to falling gas prices, an economic side effect of the virus outbreak. All told, last week’s economic gauges showed that while economic activity is moderating, it’s still enough to keep US growth on track.
What to Watch this Week: During the holiday-shortened week ahead, there’s little on the calendar that will pull markets intense focus away from virus headlines. Given the fast-evolving nature of the coronavirus, industry anecdotes regarding lost sales (e.g. Apple), interrupted production, and disrupted supply chains will provide critical early insight into how the outbreak is affecting the US economy. The release this week of a couple of second-tier gauges – regional factory production surveys for New York and Philadelphia – will provide the first clues.
Also watch the stock market as the virus headlines pass your screen, as its resilience is an implicit signal of confidence that the health of America’s corporate sector won’t be materially threatened by the worsening virus outbreak. There is still so much uncertainty about how things play out. The early evidence supports the obvious conclusion – that there will be a significant hit to current quarter growth in China. How that radiates out over time remains to be seen, however; at this juncture acknowledging that it’s too early to quantify with any sort of useful precision is really the only sensible course of action. That’s not quite the same thing as ignoring the outbreak, however. If you’d tried that, you’d have missed out on the decline in interest rates over the last few weeks.
The Big Picture: With concerns of slowing global growth mounting and little evidence that other sectors of the US economy are poised to pick up the slack, America’s growth outlook is totally dependent on consumers buying shiny new stuff. For now, the US economic outlook remains strong enough for the Fed to keep interest rates on hold, but the recent slowdown in consumption patterns from last year’s torrid pace has exposed the economy to exogenous shocks, like Boeing’s halt in 737 Max production and supply chain disruptions emanating from the coronavirus.
For interest rates, the wall of cash that’s buying US Treasuries is a boon to American taxpayers as the federal deficit balloons, keeping Treasury yields stuck near all-time lows. Even the surging stock market, ever-larger debt issuances by the US Treasury and the ultra-tight job market are failing to move interest rates appreciably higher. The trend is only gaining speed as the spreading coronavirus casts doubt on the global growth outlook. All told, we have a scenario that’s ensuring rates will stay ultra-low for even longer.
In such an environment, what’s a borrower to do? Knowing that you’ll have to refinance at an unknown interest rate in the future someday, consider entering into interest rate hedges that will take some of sting off that uncertainty while gaining a financing edge on your competition. Now’s the time to get strategic and garner competitive advantage via your interest rate risk management. Ask us how.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
LIBOR Futures Curves:
Source: Bloomberg Professional
10-year Treasury:
Source: Bloomberg Professional
