Tales from the Trenches - SOFR Conversion Mayhem

What You Missed

Economic data in the past week hammered home the need for interest rates to stay higher longer than markets expect. However, given the impending debt ceiling crisis and banks’ tightening lending standards, we expect the Fed to pause its hiking campaign in June and hold rates steady through the end of the year. Still think the Fed will cut interest rates in 2023? It’s looking less likely by the day.

Running the Numbers: Rates Treaded Water and Volatility Fell

Rates across the maturity spectrum treaded water last week, as the crosscurrents of a persistently robust jobs market, stubbornly high inflation, a debt ceiling crisis, and tightening lending standards kept markets searching for direction. For the week, the 2, 5, 10 and 30-year Treasury yields fell a respective 2, 1, 1 and 1 basis points. The stagnation in short-term yields maintained pressure in the 2s-10s yield spread, a widely watched barometer of recession potential, to trade at -51 basis points, well off its most inverted recent level (-108) from a couple of months ago. Swap rates on 3-, 5-, and 10- year maturities continue to trade at least ~50 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, remains on discount.

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose two basis points in the week to 5.09%, still shy of its all-time high near 5.12% hit back on March 10^th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell one basis point week over week, to 3.08%, reflecting the seeming indecision of traders amid the political and economic cross currents.

The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to decline over the next year as the Fed eventually eases. Swap markets are pricing around 50 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.

Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, declined steadily throughout the week, despite the ongoing debt ceiling turmoil. It’s a perfect example of the disconnect between the amount of news coverage a certain topic can have, while the media-implied “crises” isn’t reflected in markets. Elsewhere, global equities were marginally lower in the week. The price of a barrel of West Texas Intermediate crude oil was steady at $71.50, while the US Dollar strengthened, and gold weakened.

What You Missed

Economic data in the past week hammered home the need for interest rates to stay higher longer than markets expect. However, given the impending debt ceiling crisis and banks’ tightening lending standards, we expect the Fed to pause its hiking campaign in June and hold rates steady through the end of the year. Still think the Fed will cut interest rates in 2023? It’s looking less likely by the day.

Running the Numbers: Rates Treaded Water and Volatility Fell

Rates across the maturity spectrum treaded water last week, as the crosscurrents of a persistently robust jobs market, stubbornly high inflation, a debt ceiling crisis, and tightening lending standards kept markets searching for direction. For the week, the 2, 5, 10 and 30-year Treasury yields fell a respective 2, 1, 1 and 1 basis points. The stagnation in short-term yields maintained pressure in the 2s-10s yield spread, a widely watched barometer of recession potential, to trade at -51 basis points, well off its most inverted recent level (-108) from a couple of months ago. Swap rates on 3-, 5-, and 10- year maturities continue to trade at least ~50 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, remains on discount.

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose two basis points in the week to 5.09%, still shy of its all-time high near 5.12% hit back on March 10^th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell one basis point week over week, to 3.08%, reflecting the seeming indecision of traders amid the political and economic cross currents.

The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to decline over the next year as the Fed eventually eases. Swap markets are pricing around 50 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.

Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, declined steadily throughout the week, despite the ongoing debt ceiling turmoil. It’s a perfect example of the disconnect between the amount of news coverage a certain topic can have, while the media-implied “crises” isn’t reflected in markets. Elsewhere, global equities were marginally lower in the week. The price of a barrel of West Texas Intermediate crude oil was steady at $71.50, while the US Dollar strengthened, and gold weakened.

Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend

We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.

Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.

Sticky Inflation is a Prescription for Higher Interest Rates

As we all weaned ourselves off skewed consumption patterns brought on by the pandemic, the demand for services over goods helped drive prices for those goods lower. Lower goods prices helped take some of the air out of heady inflation, prompting calls from many that the dynamic spelled the beginning of the end of high and rising inflation.

That view is now starting to show cracks, with last week’s release of Consumer Price Index (CPI) data for April. Headline CPI increased to 0.4% month over month in April (up from 0.1% in March), and core inflation remained steady at 0.4%. On a year-over-year basis, that corresponds to 4.9% for the headline and 5.5% for core, ticking down from March’s 5.0% and 5.6%, respectively.

Rents are a big reason for inflation remaining stubbornly high, as they account for a large portion of the CPI. The Fed expects rents to drive the retreat in inflation through the rest of the year, and last week’s data support that view. Rents rose 0.6% in April, up from 0.5% in March but down from a long stretch of 0.8% readings before that. Similar to the previous month, owners equivalent rents ticked higher by 0.5%, smaller than the 0.7% average for the majority of last year.

Our take: Headline CPI is still far higher than the 2% the Fed is attempting to engineer via interest rate hikes. However, it won’t prompt the Fed to announce another rate hike in June given their expectation that the full disinflationary impact from tighter credit conditions hasn’t yet materialized. On the flip side, the Fed’s slow progress in reducing core inflation means that it’s unlikely to cut interest rates anytime soon. Do you believe the Fed will cuts rates this year? The data says you’re probably wrong.

Consumer Inflation Expectations Surge with Higher Gas Prices

While the Fed is justifiably concerned with the state of inflation now, it’s also equally focused on how consumers – who drive 75% of America’s economic activity – expect inflation to behave in the future, as it directly impacts their appetite for spending.

In the University of Michigan’s preliminary consumer sentiment survey for May, long-term inflation expectations increased to 3.2%, just 10 basis points shy of the level last June that prompted the Fed to shift to jumbo-sized 75-basis point rate hikes. The shift in sentiment can be blamed on an increase in gasoline prices, brought on by OPEC+ production cuts (Ever wonder why we mention the price of oil week after week? Now you know.).

Inflation has been steadily eroding consumers’ purchasing power. The consumer sentiment survey implied that most consumers – over 50% – now expect a decline in their inflation-adjusted incomes in the coming year, the highest percentage since November 2022.

Our take: With consumer confidence in the economy for the year ahead falling 23% from April, they’re clearly concerned about the long-term trajectory of the US economy and are likely losing faith that any recession will be brief and shallow. That’s further evidence that the Fed will likely shift to a pause in its rate hiking campaign as it meets again in June.

Shrinking Demand for Credit, Rather than Supply, Craters Bank Loan Volumes

The results of the Senior Loan Officer Opinion Survey conducted by the Fed are in, and the headline news isn’t good – just not in the way you might expect.

Although demand for commercial and industrial (C&I) loans completely collapsed last quarter, lending standards for both large and small businesses were only slightly tighter. When one compares the two metrics – decreased demand for C&I loans minus tighter lending requirements for such loans – we find that the spread is in ranges previously only observed during recessions.

Looking ahead, the survey results suggest that banks anticipate tightening standards even further across industries, specifically in commercial real estate, citing several justifications (such as declining loan performance and collateral values, risk aversion, liquidity, etc.). Although the survey claimed that standards for consumer loans were tightened more noticeably, it’s doubtful whether it will make much of a difference given that credit card rates have already reached highs last seen in the 1970s.

Our take: The survey showed that the deterioration in lending standards to businesses was modest, but the drop in demand was much more notable. This echoes what we’re hearing in our daily conversations with borrowers, mortgage bankers and lenders. While pretty much everyone expects lending standards to tighten in the months ahead, the credit supply/demand dynamic implies that we’re already in an economic recession. That’s not a great combination, but until this much feared credit tightening phenomenon shows up in actual activity data, like building permits, raw materials orders and the like, it will remain just that, a fear.

What to Watch: Debt Ceiling Negotiations to Steal the Show

Financial markets will be hyper vigilant in the days ahead for any signals coming out of Washington that give clarity to whether the US will careen toward another last-minute debt ceiling agreement or a catastrophic credit default.

As the window to raise the debt ceiling rapidly closes, the drip-feed of economic data and remarks from Fed officials are poised to take a rare backseat to the political drama. The US Treasury department issued a warning on Friday, saying that as of May 10, it only had $88 billion in cash available before it exceeds the debt ceiling, and hasn’t done so already only because it’s using “extraordinary measures”, aka accounting gimmicks.

Will the US default? No way. Despite the incessant news coverage and political drama, there’s zero chance that our beloved politicians will send us off the default cliff. The stakes are simply too high and will hurt everyone. Politicians will find a compromise, but not until the last minute. They always do. Every. Single. Time.

Until then, economic data on tap are likely to imply more economic weakness, giving the Fed more ammunition to choose to pause its rate hiking campaign despite inflation’s stickiness. Retail sales (Tuesday) will reveal that, despite April’s record-breaking auto sales, most other categories of demand were weak. Factory related data (Empire Manufacturing, Monday, Industrial Production, Tuesday, and Philly Fed Business Outlook, Thursday) will show that manufacturing continues to decline, and that producers are reluctant to hold excessive inventories (business inventories, Tuesday), fearing that demand will weaken in the second half of the year.

Case Studies: SOFR Conversion Mayhem – Borrowers Beware

The conversion from LIBOR to SOFR is creating last-minute confusion for borrowers, lenders, and banks that serve as counterparties on interest rate caps and swaps. Trust us when we tell you that we’re tired of bringing up the topic; we’d rather be telling you about the dynamics affecting interest rates and sexy opportunities to hedge interest rate risk. Unfortunately, the chaos we’re seeing around converting a loan, cap andor swap from LIBOR to SOFR forces us to keep you informed. Why? It’s ugly, plain and simple, and is costing borrowers more money than it should.

Case study #1

A client with a LIBOR indexed swap was required by their bank to convert the index in the swap to SOFR. The bank didn’t inform the client that converting from LIBOR to SOFR on the swap would result in a payment to the borrower. We told the bank there should be a credit due the borrower. The bank was surprised we brought it up; it told us that many borrowers with swaps don’t realize a credit to convert is due them. It took a couple of weeks for the bank to provide the estimated credit due. The loan amendment language was confusing about which SOFR index they were going to use for the loan. The economics of which index to use impacted the credit due. To arrive at a conversion solution, we first had to determine the SOFR index calculation the bank was going to use for the loan, as the swap had to match that index. Believe it or not, the bank wasn’t sure which index it was going to use, even though LIBOR’s transiton to SOFR has been years in the making.

We predicted long ago the conversion was not going to be easy, but some of the issues we’ve encountered recently have surprised us. How could a large bank have SOFR index issues when the mandatory end date for LIBOR is June 30^th, 2023? Next step after we got the index clarified was to estimate the credit due the client. We estimated the credit should be $100k. The bank provided an indication of $50k. After numerous emails the bank finally quoted $100k. We don’t think the bank was trying to take advantage of our client because there is an understandable complexity to converting LIBOR to a specific SOFR index. Had we not been engaged by the borrower, they would have received $0 as a result of the conversion and not known any better. As a direct reult of our analysis and negotiating with the bank, the credit due the borrower went from $50k to $100k.

The lesson? There’s nothing routine about converting a loan, rate cap or swap from LIBOR to SOFR. Every situation is different and has unique economics. Seek an outside advisor to manage the conversion to SOFR.

Case Study #2

We were engaged to convert an interest rate cap to SOFR. In this case it was clear that the index would be 1M CME Term SOFR. In the direction letter from the lender the effective date of the conversion was 7-1-23. The bank cap counterparty quoted a credit based upon an effective date of 5-1-23. Our email chain clearly stated the effective date should be 7-1-23. The day before the scheduled conversion of the rate cap, we requested an estimated credit due the borrower. The quote from the rate cap bank was $0.

At the scheduled time we reviewed the conversion details with the bank with our borrower client on the line. The bank’s trader said the effective date would be 5-1-23. When we corrected the trader the effective should have been 7-1-23 the dealing price credit was 20% lower. After the trader reviewed the email chain, the response was they made a mistake and would only credit the lower amount. Not acceptable because the paperwork clearly stated 7-1-23. After a few moments with the trader to acknowledge the error and our clearly defined economics, the conversion executed was honored in favor of our client. We always review confirmations, and in this case, there was a minor mistake, but one that would’ve created additional time to correct after the fact.

The lesson here? Rate cap banks are swamped with the conversion, and confusion is prevalent amongst lenders. We want to emphasize that converting a hedge from LIBOR to SOFR is complex and going at it alone could easily have negative economic consequences. Once you execute there is no going back. Are you converting your loan, rate cap or swap nrom LIBOR to SONR without an expert looking over your shoulder? Do so at your own risk.

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