What to expect as LIBOR, one of the world's key reference rates, is phased out in favor of new measures.
LIBOR, the London Interbank Overnight Rate, has for years served as a fundamental benchmark for short-term interest rates. Yet LIBOR is being phased out over the next two years – and the hard task of replacing it falls to a host of specialized industry groups that include both central banks and financial institutions.
In the US, the new benchmark will most likely be the Secured Overnight Financing Rate (SOFR), a measure of the cost of borrowing cash overnight collateralized by Treasury securities. Since April 2018, the New York Fed has been publishing daily values for SOFR; comparing SOFR and 3-month US dollar LIBOR highlights two key differences.
Daily Rates: SOFR vs. 3-Month LIBOR
Chart courtesy of Western Asset. Source: Bloomberg, as of 6/28/19 Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
First, SOFR is based on U.S. Treasuries – secured debt that’s essentially risk-free. LIBOR, however, is based on rates for unsecured interbank overnight debt. That difference in risk accounts for part of the difference between the rates, according to Western Asset. Second, SOFR is available in only one maturity – overnight. LIBOR, however, is also offered in 1-, 3-, 6- and 12-month maturities. How to replace LIBOR for longer maturities is a question not yet settled.
With about $200 trillion in dollar-denominated financial instruments that currently utilize LIBOR as the basis for rates, a smooth transition to SOFR is clearly important to financial markets over the next two years, if not beyond.
On the rise: Global Manufacturing
While too early to call a trend, the JPMorgan Global Manufacturing PMI1 has been moving upward slightly from its July low of 49.3, coming in at 49.8 for the end of October. Reaching 50 would indicate a transition from contraction to growth. The upswing is a welcome development in an environment marked by pessimism about global growth. In the Eurozone, manufacturing PMI has also moved up slightly, though remaining in contraction territory at 45.9 for October. And in Germany, the Ifo Institute2 reported expectations among its manufacturers edged up slightly in October.
These mild upswings appear to be signs of stabilization rather than an impending growth spurt. They could also be indications that the latest global round of monetary easing is starting to gain traction.
On the slide: Global bond prices
The selloff in global bonds that began in early September appeared to solidify. U.S.10-year Treasury yields rose some 42 basis points (bps) between September 3 and November 6, to about 1.853%. Yields for 10-year German Bunds rose to about -0.31%, some 40 bps; France’s 10-year rose to -0.01%. The effect on total returns was typified by the Bloomberg Barclays U.S. Aggregate Bond index, which fell some 0.95% between September 4 and November 4, the most recent figure available.
Behind the sell-off appears to be renewed optimism about the prospects for some form of resolution of the trade disputes between the U.S. and China, along with positive economic news from the U.S. regarding employment and a U.S. earnings season that contained fewer disappointments than expected.
Note: The year for all dates is 2019 unless otherwise indicated.
Unless otherwise noted, all data Source: Bloomberg, as of November 5, 2019.
1 The J.P. Morgan Global Manufacturing PMI gives an overview of the global manufacturing sector. It is based on monthly surveys of over 10,000 purchasing executives from 32 of the world's leading economies, including the U.S., Japan, Germany, France and China which together account for an estimated 89 percent of global manufacturing output.
2 The Ifo Institute for Economic Research is one of Germany's largest economic think-tanks Ifo is an acronym from Information and Forschung (research). Ifo is widely known for its monthly Ifo Business Climate Index.
“Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.
The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
The London Interbank Offered Rate (LIBOR) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities. LIBOR is used as a base index for setting rates of some adjustable rate financial instruments, including Adjustable Rate Mortgages (ARMs).
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.
Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms. PMI greater than 50 indicated economic expansion; below 50, contraction.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, New York.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
One basis point (bps) equals one one-hundredth (1/100, or 0.01) of one percentage point.