SOFR, so good as issuance keeps on growing; repo tensions not anomaly

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Issuance using the new Secured Overnight Financing Rate (SOFR) has increased rapidly since the start of the year, according to a report from TD Securities’ Public Finance Department.

SOFR issuance is at about $265 billion since the beginning of 2019. While it is far less than the $811 billion of LIBOR issuance so far this year, it is far higher than the $36 billion issued in all of 2018.

“SOFR issuance should accelerate further as the Federal Housing Finance Agency (the regulator of FHLB) has mandated that the FHLBs stop using LIBOR,” TD said in the report issued late last week. “By the end of 2019 the FHLBs must stop purchasing investments that reference LIBOR and mature after December 31, 2021 and should, by March 31, 2020, no longer enter into new financial assets, liabilities and derivatives that reference LIBOR and mature after Dec. 31, 2021.”

TD noted the concerns among market participants caused by the temporary spike in SOFR to 5.25% on Sept. 17.

“The sharp increase in government repurchase agreement rates (repo) occurred as cash left the financial system which forced a sharp increase in the cost of funds,” TD said. “The Fed subsequently stepped in with temporary repo operations and we look for the Fed to announce Treasury purchases in October in order to add reserves to the system (and prevent this situation from reoccurring in the future.)”

They noted that most contracts referencing SOFR use one- or three-month average rates, meaning the SOFR spike would have had only a marginal impact on interest payments. The New York Federal Reserve will release one- and three-month compounded average SOFR rates in late 2019 or early 2020, making it easier for investors to issue using SOFR, according to TD.

“SOFR futures open interest has increased dramatically in recent months, rising to over $1 trillion despite having launched just 18 months ago,” TD said.

Separately, BNP Paribas stressed that last month’s repo tensions were not an anomaly.

“Front-end pressures have been intensifying since the middle of last year,” Shahid Ladha, BNP’s head of G10 rates strategy, said in a market comment released late last week. “With small changes in demand for funding having large impacts on funding rates, we have reached the lowest comfortable level of reserves (LCLoR) at around $1.4 trillion. Structural collateral/liquidity imbalances result from the complex interaction of fiscal, monetary and macroprudential policy.”

Ladha sees several actions the Fed will be taking in the near-term.

“To maintain an ample reserves system and move clear of scarcity, we estimate the Fed needs to add nearly $400 billion of liquidity over the next year. The Fed is likely to shift balance sheet policy to formally target liabilities (from managing assets),” Ladha said.

“Since June 2018’s [interest rate on excess reserves] adjustment, the Fed’s response function to the growing collateral/liquidity imbalance has been reactive not proactive — necessary but not sufficient," he wrote. "The N.Y. Fed successfully intervened with temporary open market repo operations.”

Ladha said that a bolder response was needed to keep control of front-end rates, maintain smooth U.S. Treasury auctions, limit contagion into other assets and reduce any undesired side effects into the banking system.

Monday’s economic report
U.S. consumer credit increased more than forecast in August as school loans and other non-revolving debt rose by the most in three years. B;oomber News reported.

Total credit climbed $17.9 billion from the prior month, after a revised $23 billion gain in July that was the largest since late 2017, Federal Reserve figures showed Monday. The median estimate in a Bloomberg survey of economists called for a $15 billion increase. Outstanding non-revolving credit jumped $19.8 billion.

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SOFR LIBOR Monetary policy Federal Reserve