Market Snapshot
Investor optimism over a fiscal stimulus deal before next week’s U.S. elections is fading while rising COVID-19 cases across the U.S. and further restrictions in Europe endanger economic growth. USD rates drifting lower with the 10-year treasury trading 2.6bps lower to 0.816%. Moving in tandem with yields, U.S. equity futures point to a nearly 1% drop at the open with the S&P 500 0.94% lower to 3,419.25. Meanwhile, the US Dollar is rallying against most G8 currency pairs with the exception of the British Pound as investors remain hopeful that a UK-EU trade deal can be had by Wednesday.
ISDA Provides Solution for SOFR Migration
Last Friday, the International Swaps and Derivatives Association (ISDA) released a standardized contract that will allow end-users of derivatives to incorporate SOFR transition clauses into their agreements. Many market participants have already adhered to the protocol including many derivative dealers, Agencies, asset managers, and the central Bank of England.
- The clearing houses, including LCH and CME, began the shift from LIBOR discounting to SOFR discounting on cleared derivatives on October 16. Trading volume on SOFR futures and swaps has reached record levels in recent days clearing over $84 billion as of last Thursday.
- The supplement to the 2006 ISDA Definition is forward-looking and does not amend existing transactions. The impact is across various ISDA documentation including master agreements, credit support documents, and confirmations.
- The effective date is based on the later of January 25, 2021, or the date on which the second of two parties adhere to the protocol.
Permanent Triggers:
Upon the occurrence of any of the following specified events, calculations based on an IBOR will switch to a fallback benchmark:
- Pre-Cessation
- This occurs if the FCA, the regulatory supervisor, were to announce that LIBOR has or will become “non-representative” as of a specified future date.
- Permanent Cessation
- This occurs if an announcement that LIBOR will cease or has ceased permanently is made by (1) the LIBOR administrator (ICE Benchmark Administration), (2) the UK FCA (Financial Conduct Authority) or an insolvency official, resolution authority, or insolvency court for the administrator, or (3) the central bank (the Federal Reserve).
Permanent Fallback for LIBOR:
- SOFR, the Secured Overnight Financing Rate is a measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. It is calculated and published by the Federal Reserve Bank of New York.
- As a fallback rate, SOFR will be compounded in arrears over the current interest period, observed with a two business-day backward shift (will start two Business Days before the relevant period and end two Business Days before the end) and a spread adjustment (will be based on a five-year historical median looking and the compounded risk-free rate.)
UST 10-Year Yield Continues to Climb
Some investors have not forgotten the volatility experienced in 2016 when 10-year rates had hourly swings of +/- 35bps before rising 50bps in the weeks following the election.
Investment managers continued to pile into the bear curve steepening trade, with long-term rates rising more than the short-end. The spread between 5s and 30s steepened to 130bps last Friday, the widest it’s been since November 2016. The 10-year UST yield climbed as high as 0.868% before snapping its six consecutive days of increases as signs of fiscal stimulus talks faltered before the upcoming U.S. elections. An election result less than a Democratic sweep could send Treasury yields plummeting as bond traders unwind its interest-rate bets.
Weighing heavily on the broader market are:
- The U.S. November Elections
- While the election risk is somewhat abating due to recent polls, one can recall the polls taken in 2016 that didn’t quite pan out in the U.S. or UK.
- Investors and traders are bracing for a volatile election year as the ultimate Presidential and Senate winners may not be known until December, pushing out typical November hedges into December and January 2021.
- U.S. fiscal stimulus package
- While hopes fade for a fiscal stimulus package before U.S. elections, Treasury Secretary Steven Mnuchin and House Speaker Nancy Pelosi will keep working on a large coronavirus stimulus deal over the weekend.
- We may see long-end rates push higher, on inflation expectations, should Congress agree on a $2 trillion+ fiscal stimulus plan.
- U.S.-China relations, as both countries fight on everything from trade to defense issues, monetary policy, and the coronavirus.
- Second novel Coronavirus wave
- In a dramatic reversal in recent weeks, Europe is experiencing its second wave forcing countries to impose more strict social-distancing rules and business curfews.
- While there are numerous potential COVID-19 vaccines and therapeutics currently being developed, the limited production capabilities, timing, and acceptance for people to receive the medical solutions are of concern and could be drawn out to the end of 2021.
