SOFR away, doesn’t anybody stay in one place anymore?
It would be so fine to see your face at my door,
Doesn’t help to know, that you’re SOFR away
With apologies to Carol King
Not much love for Stanley last week, but that’s OK. He’s long gone. As we all must go. Perhaps it is well that this is so. You don’t need me to tell y’all that nothing lasts forever, but I will anyway.
Nothing lasts forever.
Case and point, this month, in addition to the other opportunities and challenges we have encountered, marked the passing of an era. The once-mighty Eurodollar futures complex, long-time alpha dog of not only the short-term interest rate markets, but indeed, of the entire futures universe, has been eclipsed in both Volume and Open Interest by a lesser-known aspirant: Secured Overnight Funding Rate (SOFR) futures.
SOFR, so good, as the man says. The Eurodollar had an extended star turn, but over its history, the fates gave many signals that its reign would be finite. It began with what appears, in retrospect, to be an unfortunate nomenclature choice. Eurodollar is kind of a cool name, but the actual underlier was the London Inter-Bank Offered Rate (LIBOR). So why not just call it that (I’ve often wondered)?
Then, in 1999, came European Monetary Union. As a matter of necessity, this created a new currency pair, called, well, called Euro/Dollar. Which led to immediate confusion, as there were thus, and ever since, two critical market benchmarks of nearly identical appellation.
The second, much larger problem began to unfold about a decade ago, when some slick bank guys manipulated the auctions upon which LIBOR is based. Not by much, only teeny, tiny amounts, fractions of percents.
But that sh!t added up. Because LIBOR was the biggest market in the world. Like, to the tune of $300 Trillion. Thrice Global GDP. And, while nobody except wonky interest rate traders pays much attention to LIBOR, it impacts just about everything with an interest rate attached to it. So, we all got ripped off. Bigly.
I’ll spare you a review of the dirty details (it’s Christmas Week, FFS!), but around 2013, the scheme unraveled, got blown wide open. A couple of cats went to jail; some banks paid fines.
And then the whole thing blew over.
Except for this. The British Bankers Association, stuffy, stolid but routinely shady sponsors of LIBOR, decided that the juice was not worth the squeeze. Started backing away from the project, albeit in a protracted fashion.
Enter SOFR – calculated by the impeccable, unassailable (at least by comparison) NY Federal Reserve. And now, after many years of doing direct battle, SOFR rules pre-eminent.
Again, SOFR, so good. Especially if you were long these puppies, which have trounced their opposite numbers in the Eurodollar pit in unceremonious fashion:
SOFR vs. ED: The Market Has Pronounced its Verdict:
OK; so this is little more than an obtuse joke. SOFR is quoted in yield, which has gone up dramatically, while ED is price based, and thus migrates in opposite direction. As such, these graphs describe an identical trend.
Which is that interest rates are rising. We kind of knew that already, and, in case we were in any\ confusion, Chair Pow reminded us, during last week’s FOMC Presser, that not only is this so, but that he ain’t done yet. Across our little global financial village, the same message was conveyed by the likes of the ECB’s Madame LaGarde and the fine folks on His Majesty’s Monetary Policy Committee.
The risk markets didn’t like what they heard. Not. One. Bit. And perhaps it’s no wonder. Our miracle of a capital economy has weathered much higher interest rate regimes than the one that currently prevails, but this does look like a major buzzkill hiking cycle. Coming, as it does, not to cool a whitehot economic surge, but against the backdrop of an unambiguously slowing one, with Inflation still hovering at > 3x the Fed’s stated target. With all kinds of pressures on margins and earnings, and various other dainties not overly pleasant to contemplate, much less ingest.
Thus, not only is the market selling off, but its longstanding leadership is being annihilated.
Goldman is sh!tcanning a few thousand bankers. SBF lingers in a rudely appointed Caribbean prison, awaiting a likely to be unpleasant extradition to the States. Frenemy Binance’s auditors suspended their review. The world’s largest cylindrical fish tank exploded in Berlin.
In all, I think it is well that we’re finally putting 2022 to bed. Not many in my professional acquaintance will much miss it. And as for ’23, well I don’t have a great deal of visibility as yet.
About all I can state with any confidence is that the first market move of ’23 is probably a big head fake fade. I’m not suggesting that the right trade is to get short an early January rally or to buy into an associated selloff, but there are worse trades I can contemplate.
I do suspect, however, that the rising tide of rate increases will ebb and ultimately reverse itself ere long. The delightfully diluted CPI print is one sign, and last week’s additional data releases corroborate the trend. Retail Sales, Industrial Production, PMIs of every stripe, confirm an unmistakable slowdown in economic activity. Which, presumably, is what the Fed intends.
The contorted yield curve remains in a gruesome state of inversion, and, just because I can, I’ll include an illustration of investors views on breakeven Inflation, as measured in 10-year equivalents:
This suggests that investors are putting their capital behind the concept that Inflation will come careening down, placing the Fed in a position to shift from “taketh away” to “giveth” mode.
To which I offer a few caveats. Yes, I expect Inflation to cool considerably next year. However, I can’t get there without factoring a Recession into the calculus. I am also, as I’ve repeatedly stated, concerned that renewed upward pricing pressure in the Energy Complex, while doing nothing to stave off the latter (Recession, that is) could upset this trajectory. Finally, to borrow a thought from a credentialed former Fed guy I just met, I believe that while the Inflation ride down to, say, 5% might easily be accomplished — still > 2x the Fed’s target– any move below this – particularly in this gnat’s ass tight Labor market — will be difficult to manifest and painful in its unfolding.
But hey, why even think about that no? There’s still two weeks that remain to our current solar circumnavigation, during which time our attentions will be diluted so as to pay proper homage to Hannukah, Christmas and New Year’s.
I wish I had something smart to offer about this final chapter. But in abstaining, please bear in mind that recently I suggested that risks tilted to the upside and gave my blessing to would be buyers.
I might recommend a combination of short SOFR/long Eurodollar, but that, my friends, is a trade, which back in the glory days of Open Outcry, known as a Texas spread.
The pits are shuttered now. SOFR has supplanted Eurodollars. It’s the holiday season, and All God’s Children are on the move. Perhaps it is well that it should be so. That no one stays in one place anymore.
And yes, it would be sooo fine to see your face at my door.
Trouble is, I won’t be home.
TIMSHEL