Volatility returns but the long end stays range-bound

| November 30, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

A transition away from forward guidance and back to data-driven monetary policy will re-establish the economy and investor risk appetite as primary driving forces in rates. The outlook for rates depends on how soon this transition occurs, and whether wider credit spreads do some of the Fed’s work for them. The overwhelming consensus is for a flat to inverted Treasury curve at a somewhat higher level. Should the Fed pause its hiking early there is a bias for steepening. Liquidity in SOFR futures should improve, particularly if helped along by increased GSE and Treasury issuance of SOFR-linked notes and FHLB advances to banks.


The broad consensus is for higher rates, a flatter curve

The overwhelming consensus view in rates among strategists and economists is for modestly higher rates and a flatter to potentially inverted Treasury curve in 2019. The view is predicated on a stable economy – supported by almost $1 trillion in new Treasury supply to fund the estimated federal deficit – and rising inflation allowing the Fed to continue hiking rates until they find neutral. The Fed itself has diagrammed the scenario with the median FOMC dots projecting the target rate at 3.125% for year-end 2019. Fundamentally that outlook appears sound: the Congressional Budget Office expects dissipating fiscal stimulus and growth in private investment will lift GDP to 2.4% in 2019 before slowing markedly in following years. The probability of a recession in the near-term appears low, and attempts to make a case that runaway inflation would spur the Fed to raise rates above 3.50% in 2019 seem downright far-fetched.

An outlier case for fewer hikes, a steeper curve

There is a growing possibility that there may be a pause in hikes in 2019, not because the FOMC acquiesces to cajoling from the Administration, but because a widening in spread products may do some of the Fed’s work for them. The re-pricing of risk – including a calving off of some of the weaker BBB credits into high yield territory – appears likely in continue in 2019. Wider spreads and steeper credit curves tighten financial conditions, pulling neutral closer without raising rates.

As the Fed transitions away from forward guidance and the path of rates again becomes data driven, intra-day volatility in the rates market should pick up, as traders and investors return to sweating out every non-farm payroll print. The consequences of a return to normalcy with the target rate at 2.75% could be a bull steepening of the Treasury curve as the front end re-prices. Volatility would increase on short tenors, but undershooting the dots and possibly the inflation target would likely result in a drop in volatility on longer tenors as the long-end of the curve remained range-bound. In this case expect the 10yT to navigate in the 2.75% – 3.30% range, with no sustained breakout on either side.

Probabilities for the Fed funds target rate: 20% chance the Fed “matches the dots”, and raises the target rate to 3.25% or above by year-end; 60% chance the Fed hikes only once or twice in 2019, increasing the rate to 2.75% or 3.00%; 20% chance the Fed pauses at 2.50% in December and does not tighten in 2019.

The trades: Stay invested in repo and the front end of the rates curve. Extend in duration and enter 2s10s steepeners if growth and inflation remain subdued. Long gamma, short vega. 


The mandate to build liquidity in SOFR

The official transition from LIBOR to the secured overnight financing rate (SOFR) is scheduled for year-end 2021. At that time the 16 LIBOR panel banks will no longer be required by regulators to submit rates at which they can obtain wholesale funding. Given the substantial civil and criminal penalties imposed on banks, traders and managers across the spectrum of panel banks as a result of the LIBOR-rigging scandal, it is considered highly unlikely that any back will voluntarily remain on the panel beyond that time.

Regulators, investors and issuers have three years to build out the overnight SOFR rate into a deeply liquid term and futures market capable of supplanting LIBOR, Eurodollar futures and swaps. The crucial scaffolding of a SOFR futures market is in place (Exhibit 1), but trading volume remains anemic compared to Eurodollar futures (Exhibit 2). What propels heavy trading in Eurodollar futures is the widespread exposure investors have on both the asset and liability side to LIBOR floating rates and LIBOR-based swaps and other derivatives.

Exhibit 1: SOFR futures (3 month)

Source: Bloomberg

Exhibit 2: Eurodollar futures (3 month)

Source: Bloomberg

The keys to SOFR liquidity: issuance and exposure

The imperative to build a liquid futures market – which will in turn allow the construction of a SOFR term structure and SOFR-based swaps market – is largely dependent on two things:

  • How quickly issuers, lenders and structurers transition to SOFR as the underlying floating rate in securities such as floating rate notes, securitized products and interest rate derivatives; and
  • How confident investors who hold SOFR-based securities or derivatives feel in their ability to hedge those exposures via the SOFR futures or swaps market.

The challenge for 2019 will be to build broad-based adoption of SOFR as an underlying floating rate by lenders and investors. The Federal Reserve and other regulators can accelerate the adoption process to some extent by encouraging the GSEs – in particular the Federal Home Loan Banks (FHLBs) – to begin denominating new assets and liabilities tied to SOFR instead of LIBOR. The FHLBs are significant issuers of LIBOR-based floating rate notes, which banks and other investors hold as assets; and also extensively lend money to banks via the advance programs, which are often tied to LIBOR and swap rates. Bank and investor exposure to SOFR on both the asset and liability side would encourage interest rate hedging via SOFR futures.

The Treasury Borrowing Advisory Committee (TBAC) has recommended that the Treasury consider issuing SOFR-based floating rate notes. This would also encourage adoption and create additional demand for SOFR futures among those wishing to hedge their risk. Although Treasury has not announced a SOFR-based floating rate note program yet, it is possible that they will do so and that the first Treasury SOFR floaters could be issued in the second half of 2019.

john.killian@santander.us 1 (646) 776-7714

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