[VIDEO] A Red Herring: Our view on the ECB announcement

Mario Draghi’s penultimate policy meeting yesterday brought a rate cut, the return of QE, and some assistance to Europe’s beleaguered banking sector. But will it have the intended effect of stimulating the Eurozone? Watch now to see our take on the ECB policy changes.


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ECB Meeting – Steady As She Goes

The ECB left rates and the asset purchase target unchanged at their September monetary policy meeting.

The meeting was accompanied by the ECB staff macroeconomic projections, which showed a marginal reduction in the growth forecast versus the projections released in June. Real GDP growth in 2018 was lowered to 2% from 2.1%, in 2019 to 1.8% from 1.9% and in 2020 left unchanged at 1.7%. The risks to this forecast remain “broadly balanced” as communicated in previous policy meetings.

On the inflation front, the headline Harmonised Index of Consumer Prices (HICP) forecast was left unchanged at 1.7% until the end of 2020. Underlying this was weak oil prices being offset by “significantly stronger” core inflation driven by rising wages.

There was no discussion on reinvestment of the asset purchase programme redemptions, with Draghi suggesting that the likely date for this would be October or December.

The worries in Italy, Argentina and Turkey were, in Draghi’s view, reflective of weak fundamentals and as such contagion has been limited, with Italy viewed as an “Italian episode”.

Rates markets rallied however this is more likely reflective of the lower than forecast inflation number out of the US, released at the same time as the press conference.

All in all, no material information and we continue on the ECB glide path.

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LIBOR, it’s all coming to a dramatic end!

You need an interesting title when writing about a topic that tends to have people nodding off after the first sentence. So what is the deal with this LIBOR thingy then?

LIBOR – the London Inter-bank Offered Rate – is going down the drain, thanks to the traders who decided to make up the rate for the next day’s cost of overnight money at dinner one night. We always knew that the Libor fix was a bit dodgy in some of the less transparent overseas markets. That’s why some interest rate swaps trade versus the very liquid USD floating rate and not the domestic floating interest rate (think Russia and Turkey). But for a more established market such as the UK, the scandal was a bit of a shock, though probably a good thing in the long term given that the changes being introduced will make the rate materially more robust and trustworthy.

I have written about the story before, but it’s worth updating a few points.

Firstly, the US Federal Reserve has begun publishing its new overnight reference rate in the US – SOFR, or the Secured Overnight Financing Rate. This is a little different to the UK SONIA rate (Sterling Overnight Index Average rate) as the US SOFR is based on secured transactions as opposed to SONIA’s unsecured rate. (Typically a secured funding rate is lower as the lender receives security against government bonds).

Going forward, the Chicago Mercantile Exchange (CME) is going to launch futures contracts on the new rate, adding to the existing EuroDollar futures market. Later this year, clearing will start for SOFR swaps. So while we are a long way off replacing the LIBOR swap market in the US, it’s the direction of travel.

Over here in the UK, the SONIA fixing is getting a fancy new haircut and shiny new trainers: it’s going to be “reformed”, with more breadth of transactions and a slightly different averaging calculation. So we get a nice trustworthy benchmark, administered by the Bank of England, which we can all transition to from the market’s LIBOR legacy book.

Think about that last line a minute: “that we can all transition to from the market’s LIBOR legacy book”. Who has a legacy book?

Investors using a liability-driven investment strategy (LDI) have a legacy book. Many practitioners in LDI swap their long-dated cash flows (think 30, 40, 50 years) using LIBOR. The market will need to replace LIBOR when it is finally retired (date to be determined). So we have seen a pickup in new hedging being done in SONIA as opposed to LIBOR. This can be seen in the spread between the LIBOR and SONIA rates, which has moved noticeably as shown in Chart 1 below.

Chart 1: 30-year LIBOR – SONIA swap spread

Source: Bloomberg.

How does this affect a pension mandate then?

Most schemes using swaps are ‘in the money’, as those that have ‘received fixed’ from an older, higher interest rate environment now have a paper profit.

In all of these in-the-money swaps, there is a risk of the current discount curve (SONIA) moving differently to the forward curve (Libor) – so the market needs to pay close attention to SONIA moves relative to LIBOR. Guess what? That’s happening now!

How far this relationship goes and the implications for numerous pension schemes is unclear, but what is certain is that it’s a regime change, so expect a bit of a ride.


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A Liborious task ahead

Yesterday the CEO of the FCA, Andrew Bailey, gave a speech in which he supported ending the publication of LIBOR (London Inter-Bank Offer Rate), the key risk-free reference rate used by the financial system in the UK. In general the comments were nothing new – this has been a project in progress by the Bank of England for many years – so why did the market pay so much attention to the comments? Well, the intent implied in Bailey’s speech was more than the market expected, as well as there being a specific time frame mentioned: 2021.

What is the problem with LIBOR?

There are two main issues with using LIBOR as a reference for risk-free interest rates. Firstly, the most common LIBOR rate used is the 6-month LIBOR (the rate at which banks will lend cash on an unsecured basis in the interbank market for a term of 6 months). The fact that this rate is for a 6-month loan implies that it is not actually a risk-free rate – it carries a 6-month term premium. The second main issue is the way that the LIBOR rate is set, as it relies on banks to submit an estimate of where they think they can lend money. As it is not based on actual traded transactions, it is subject to gaming – as was seen in the well-publicised LIBOR scandal. To solve these issues, the Bank of England working group on sterling risk-free rates proposed in April that SONIA should replace LIBOR and be administered by the Bank of England.

What is SONIA?

The Sterling OverNight Index Average (SONIA) is a reference rate that is based on actual transactions in the overnight unsecured loan and deposit market. Reformed SONIA will actually replace SONIA shortly; reformed SONIA includes other market participants outside the interbank broker market and therefore has a much higher transactional volume than current SONIA.

What would the change mean for the derivatives market?

Currently LIBOR is used as the reference rate for the majority of interest rate derivatives held by end users and used to hedge a variety of liabilities, bonds, loans and other financial instruments. As a result the LIBOR swap market is the most liquid and cost effective hedge, as well as being a match for existing legacy LIBOR derivative positions held by end users. There is also a liquid market in SONIA swaps, however liquidity falls once the maturity of the trade becomes longer than 5 years.

The SONIA swap market has existed for around 10 years, so why have market participants not voluntarily migrated to SONIA? This is a legacy issue. The market agrees that if we were to design the market again from scratch, LIBOR would not be the main reference rate. But with so much of the market already using the fix, it’s not easy to wean off it! The market needs a regulatory push, the FCA and BOE do not see LIBOR as a desirable reference rate, and the comments yesterday are the next step in this process.

Much of the current derivatives trading is facilitated by the large and liquid pool of short sterling futures contracts. For the market to adopt a new reference rate such as SONIA, there needs to be a successful SONIA futures market established, something which is currently being consulted on by the Bank of England working group. Another issue that needs to be resolved is the ability to centrally clear SONIA swaps with maturity longer than 30 years, which is the current maximum – again a focus for the working group.

Clearly the FCA and BOE are intent on moving the market away from LIBOR over the long term. The working group has the (big) job of consulting on this transition and are seeking input from all market participants. There are undoubtedly challenges ahead – but change can be a good thing. This is a global theme with similar projects happening in the US and elsewhere, with the collective ambition of benefiting all market participants.

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