✌️ Welcome to the latest issue of The Informationist, the newsletter that makes you smarter in just a few minutes each week.
🙌 The Informationist takes one current event or complicated concept and simplifies it for you in bullet points and easy to understand text.
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Today's Bullets:
What is SOFR?
SOFR vs Fed Funds
Remember September 2019?
Hang on Tight
Inspirational Tweet:
With all the recent talk of soft landings and the immaculate disinflation (whatever the heck that is), it's hard to imagine that there could possibly be a problem anywhere in the financial system right now.
Near full employment. Persistently strong retail buying. Housing prices seemingly holding up. And a stock market on a rocket ship trajectory.
Priced to perfection, some would even say.
But should it be?
Is there anything that could knock the economy or systematically important companies or entities off kilter?
As my good friend Preston Pysh points out here, a possible red flag was just raised in the SOFR market.
If you have no idea what SOFR is, have no fear. We are going to unpack and clear it all up for you right here today, nice and easy as always.
So, grab your favorite cup of Joe and settle into your favorite chair for the last Informationistnewsletter of the year.
🤓 What is SOFR?
Put simply, SOFR (the Secured Overnight Financing Rate) is a calculated average interest rate for borrowing cash overnight that is collateralized by US Treasuries.
You hand them Treasuries, they hand you cash.
You pay the cash back the next day or two (plus a small financing charge), and they give you your USTs back.
Easy peasy.
See, SOFR was created by the Federal Reserve Bank of New York in 2018 in order to move away from the original LIBOR benchmark.
For those who don't know what LIBOR (the London Interbank Offered Rate) is, it was created in the 1980s as a global benchmark for short-term interest rates.
LIBOR was based on the rates that banks charged each other for short-term loans.
However, LIBOR was found to be constantly manipulated, and so SOFR was created to replace that benchmark with a measure of Fed oversight.
A few differences though.
First, SOFR is based on actual transactions in the private overnight Treasury repo market vs. LIBOR, which was calculated from estimates submitted by various banks.
And so, SOFR represents a weighted average of actual transactions rather than an average of estimates (you can see how this could be manipulated, right?)
Also quite important, SOFR is based on transactions that use USTs as collateral, as opposed to LIBOR which used rates based on completely unsecured loans.
However, they do have some differences:
So, SOFR has better transparency and is resistant to manipulation.
As a result, SOFR is quickly becoming the standard in USD-based loans, derivatives, and debt instruments, replacing LIBOR almost entirely for the benchmark of short-term lending rates.
As far as who uses the SOFR rate (outside of the actual banks making overnight loans), this is primarily banks and financial Institutions for various financial products, including loans and derivatives, as well as investors who use SOFR as a hurdle rate for performance and rates on short-term loans, etc.
You may now be asking, why the need for SOFR at all?
Why not just use the Fed Funds rate for all this?
🧐 SOFR vs Fed Funds
SOFR and the Federal Funds Rate are both key interest rates, but they serve different purposes and are derived from distinct sources.
As we said above, SOFR is based on the actual cost of borrowing cash overnight that is secured by US Treasuries in the private repo market.
The Fed Funds Rate is the target interest rate set by the Federal Open Market Committee (FOMC) for overnight loans between financial institutions, and the Effective Fed Funds Rate (EFFR) is a weighted average of the actual interest rate that banks charge each other for these overnight loans.
The Fed Funds Rate is a target set by the Fed and the Effective Fed Funds Rate is the actualrate used in the market.
And most importantly, unlike SOFR, loans using the EFFR are unsecured.
As you can see, they are quite different in practice.
That said, when looking at SOFR versus EFFR, we get some clues on bank liquidity and possible problems in the financial system.
When the spread between the two measures spikes (SOFR rate is much higher than EFFR), this can be a red flag that a liquidity problem is brewing at banks or a large financial institution is in trouble.
So, where that spread today?
oops?
The spread between SOFR and EFFR just blew out on the last day of the year, jumping to a level above even the SVB banking crisis this past spring.
Does this mean that there is a problem brewing in the banking world? Is there a hedge fund blowing up or a major bank heading for insolvency?
After all, the spike in spread is because the SOFR rate jumped, which is indicative of a sudden need for liquidity by a large or a large number of financial institutions.
What gives?
First, we must recognize that this happened on the last banking day of the year.
There is often quite a bit of re-balancing and balance sheet adjustments for large and small banks and investment funds alike on this particular day. They often use US Treasuries as collateral to access necessary cash for leverage calculations, margin requirements, or other purposes.
A sort of window dressing, as it is known on Wall Street.
Also, we need to put in context just how big of a spike this was in reality. As, though it seems large in context of the last year or two, let's take a peek at a true liquidity crisis.
Anyone recall the Repo Crisis of 2019?
🤔 Remember September 2019?
For those who don't recall or weren't paying attention to things like this back then, the repo market crisis in 2019 nearly melted down the entire lending market.
How?
In short, a sudden spike in interest rates in the repo market threatened liquidity across all assets and the stability of the US Treasury market.
Why?
Well, a combination of factors led to the sudden shortfall in liquidity on September 16th, 2019.
First, the due date for quarterly corporate tax payments that day led to companies making large withdrawals from banks and money market funds.
Second, there was a large $54 billion Treasury auction from a few days prior that required settlement on the very same day.
I.e., the buyers of the Treasuries in the auction had to pay for them.
These two events created a temporary but significant shortage of cash in the system.
It basically drained the cash in the private repo market.
Nice planning by the Treasury.
It was all exacerbated by a prior decline in bank reserves due to the Fed continuing QT, selling the Treasuries and mortgage backed securities it had 'accumulated' in the Great Financial Crisis.
$4.5T worth.
You can see they didn't get very far before having to reverse course and start QE again.
So, how much did SOFR spike, and how bad did the spread between SOFR and EFFR get?
Would you believe 295 basis points?
That's right, the spread between SOFR and EFFR was almost 3 full percent.
Hello, Janet? This is Jerome. Yeah, we have a problem.
Then in comparison, today's 7bp spread looks like a teeny little blip on the illiquidity radar in the context of September, 2019.
Back then, interest rates on some overnight repo transactions spiked up to 10 percent, and the SOFR benchmark hit 5.25 percent for the day.
Liquidity was so strained that the Fed Funds Effective Rate pushed above its target range to 2.3 percent.
The Fed's response?
The New York Fed announced that it would step in and lend cash to borrowers in the repo market, offering up to $75 billion in overnight repos daily. This continued for several months, until the market fully stabilized.
Of course, then we had the Covid-led crash of 2020.
More illiquidity. More crisis. More money printing.
You can see where I am going with this, right?
🫣 Hang on Tight
If you have been following me on Twitter/X or reading The Informationist, then you know that I am sincerely concerned about the sheer amount of Treasury debt that will soon be required to finance the massive federal deficits the government is running.
The Treasury has been walking a tightrope, issuing short-term T-Bills and sucking liquidity out of the Reverse Repo market.
As this is being drawn down, however, the need for overnight repo borrowing has increased, as evidenced below.
This is likely due to decreased bank reserve balances and banks' (and other financial institutions) increased cash needs.
And so, banks and financial institutions are increasingly using their USTs to fund short-term cash needs or obligations.
Eventually, the Reverse Repo Facility is drained and financial companies turn to the repo market in earnest for liquidity. They will pay the SOFR rate, whatever it is, when they need it.
If this sounds ominous, it isn't that bad yet, and there is a new Fed safety net to prevent a liquidity meltdown like September 2019.
See, on the other side of the Fed Reverse Repo Facility is another new Fed operation, the Standing Repo Facility.
This was created in 2021, after the crises of September 2019 and March 2020.
The SRF offers overnight repos daily, allowing banks and financial institutions to obtain funds (cash) from the Fed against US Treasuries and mortgage-backed securities (MBS).
Once that Reverse Repo Facility is drained, it's going to be difficult for the Fed to continue competing with the Treasury by selling USTs themselves.
So much for QT.
I mean, does anyone really believe the Fed will continue selling the $7.7T of securities it has on its books once the majority of companies are either borrowing against or just plain dumping USTs for much-needed cash?
Me neither.
Bottom line, everywhere I turn, I see the possibility of some sort of leverage and liquidity-driven credit event that creates an ever larger spike (than this weeks') in the SOFR rate, serious illiquidity in the Treasury market, and the absolute emergency need for the Fed and the Treasury to step back into the markets to shore them up with additional liquidity.
Money printer go brrrrr.
But make no mistake, a large-scale credit event like 2019 or worse would be painful and cause severe drawdowns in the markets.
With the money printer, the drawdowns may be short-lived. But they will affect some assets quite differently than others.
And so, knowing this, I personally maintain a balanced and well-diversified portfolio that includes short-term USTs and fully insured FDIC cash, as well as gold and other commodities and a semi-hedged portfolio of equity exposures.
Because who knows how bad it gets before the Fed has to step in and print again.
One thing is for sure, though, they will print again.
And again.
And again.
That’s it. I hope you feel a little bit smarter knowing about SOFR, LIBOR and the Effective Fed Funds Rate and how liquidity in these markets can affect overall markets.
If you enjoyed this newsletter and found it helpful, please share it with someone who you think will love it, too!
Happy New Year, and here's to a great 2024!
James✌️