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Get Ready for SOFR and SONIA and ESTR

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Get Ready for SOFR and SONIA and ESTR November 05, 2020 Economics Group Special Commentary Jay H. Bryson, Chief Economist [email protected] ● (704) 410-3274 Michael Pugliese, Economist [email protected] ● (212) 214-5058 Hop Mathews, Economic Analyst [email protected] ● (704) 383-5312 Get Ready for SOFR and SONIA and ESTR Executive Summary The United States is not the only economy in which LIBOR is scheduled to be replaced by another benchmark interest rate. As we have discussed in previous reports, LIBOR will be replaced by SOFR as early as the beginning of 2022. The United Kingdom is currently preparing to switch from sterling LIBOR to SONIA (Sterling Overnight Index Average rate), and the Eurozone will replace euro LIBOR with €STR (Euro Short-term Rate). In this report, we provide an outlook for these three benchmark interest rates. SOFR Likely to Remain at Low Levels for Quite Some Time As we have discussed in three previous reports this year, LIBOR, which serves as a benchmark The path for interest rate for many businesses and households, is scheduled to be replaced by the Secured SOFR going Overnight Financing Rate (SOFR) as early as the beginning of 2022.1 Although there are a number forward should of technical differences between the two rates, which we discussed in more detail in the earlier generally reports, the two rates generally have a high degree of correlation with the fed funds rate (Figure 1). mirror the Accordingly, the path for SOFR going forward should generally mirror the monetary policy of the monetary policy Federal Reserve. of the Federal Reserve. Figure 1 Figure 2 Short Term Funding Rates September 2020 FOMC Dot Plot Expected Midpoint of Target Range for the Federal Funds Rate at Year-End 6% 6% 3.50% 3.50% SOFR: Nov-03 @ 0.11% EFFR: Nov-03 @ 0.09% 3.00% 3.00% 5% 1-Month LIBOR: Nov-03 @ 0.14% 5% 2.50% 2.50% 4% 4% 2.00% 2.00% 3% 3% 1.50% 1.50% 2% 2% 1.00% 1.00% 1% 1% 0.50% 0.50% 0% 0% 0.00% 0.00% 2015 2016 2017 2018 2019 2020 2020 2021 2022 2023 Longer Run Source: Bloomberg LP, Federal Reserve Board and Wells Fargo Securities In that regard, we look for the Federal Open Market Committee (FOMC) to maintain its current target range for the fed funds rate between 0.00% and 0.25% through at least the end of 2022. Although we forecast the unemployment rate will recede further in coming quarters, we do not expect that labor market conditions will have “reached levels consistent with the Committee’s assessments of maximum employment” anytime soon. Furthermore, we do not expect that inflation 1 All three previously published reports are available upon request. This report is available on wellsfargo.com/economics and on Bloomberg WFRE. Get Ready for SOFR and SONIA and ESTR WELLS FARGO SECURITIES November 05, 2020 ECONOMICS GROUP will moderately exceed 2% “for some time” as the FOMC is trying to engineer.2 Our expectation that the FOMC will maintain its target range for the fed funds rate at the zero lower bound for a considerable period of time is consistent with the Committee’s own projections. As shown by the “dot plot,” most FOMC members currently project that they will keep rates on hold through 2023 (Figure 2). In sum, SOFR likely will remain near its current rate of roughly 0.10% for the foreseeable future. The Outlook for U.K. Monetary Policy and SONIA Authorities in the United Kingdom have chosen the sterling overnight index average (SONIA) as the preferred LIBOR successor. SONIA, as the name suggests, is an average of interest rates paid on overnight deposits in the wholesale funding market. First published in 1997, SONIA has a relatively long history compared to other new reference rates. This longer track record should facilitate the transition away from LIBOR, as SONIA is well established as a benchmark rate in sterling markets and is already used to value around £30 trillion of assets annually, according to the Bank of England (BoE). That said, the administration and calculation of the rate has changed over the past few years. The BoE took up administration of the index in 2016, before undertaking a number of reforms in order to improve the robustness of the rate and ensure its compliance with international standards for alternative reference rates. In its current form, SONIA is calculated as a trimmed, volume-weighted average rate based on unsecured overnight transactions greater than or equal to £25 million in value.3 As with SOFR and other new reference rates, SONIA was chosen to avoid some of the pitfalls of its predecessor. The index is based on transactions, rather than a survey, in a liquid market. As part of its reforms, the BoE widened the pool of eligible transactions, resulting in a pool roughly four times larger at the time the changes were being considered (Figure 3). Part of this change was to move beyond the interbank market. Indeed, banks make up a relatively small share of the transactions used in SONIA’s calculation, particularly compared to money market funds and other investment funds.4 Figure 3 Figure 4 Trading Volumes Underlying SONIA United Kingdom Reference Rates Billions of Pounds 80 80 0.8% 0.8% SONIA SONIA: Nov-05 @ 0.05% SONIA: Nov-03 @ £67.2B Reform BoE Bank Rate: Nov-05 @ 0.10% Millions 70 70 Millions 0.7% LIBOR GBP Overnight: Nov-05 @ 0.05% 0.7% 60 60 0.6% 0.6% 50 50 0.5% 0.5% 40 40 0.4% 0.4% 30 30 0.3% 0.3% 20 20 0.2% 0.2% 10 10 0.1% SONIA 0.1% Reform 0 0 0.0% 0.0% 00 02 04 06 08 10 12 14 16 18 20 13 14 15 16 17 18 19 20 SONIA is based Source: Bloomberg LP and Wells Fargo Securities on unsecured transactions, While many of these features mirror SOFR’s construction, one important difference is that SONIA whereas SOFR is is based on unsecured transactions, whereas SOFR is based on secured transactions. Therefore, based on SONIA may incorporate some degree of counter party risk. On the other hand, however, SONIA secured should not reflect fluctuations in the supply and demand of collateral. As we have seen with SOFR, transactions. 2 See our Monthly Economic Outlook for details of our macroeconomic forecasts. 3 The BoE drops the outliers of the reported rates, using only the middle 50% of reported rates to calculate the trimmed mean. 4 Bank of England (2017), ‘The Reform of SONIA: Consultation feedback and the design of SONIA’; https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/reform-of-sonia- consultation-and-feedback-and-design-march-2017.pdf . 2 Get Ready for SOFR and SONIA and ESTR WELLS FARGO SECURITIES November 05, 2020 ECONOMICS GROUP the supply and demand of the assets that are used to secure transactions, namely government bonds, can at times have meaningful effects on the behavior of secured money market rates. SONIA tracks quite closely with the BoE’s main policy rate (i.e., the Bank Rate), and SONIA has printed in a very tight range of 0.051% and 0.075% ever since the Monetary Policy Committee (MPC) of the BoE cut the Bank Rate to 0.10% on March 19 (Figure 4). Looking forward, we forecast SONIA tracks that the MPC will maintain the Bank Rate at 0.10% for the foreseeable future. Consequently, SONIA quite closely should remain well-anchored near current levels. The current output gap in the U.K. economy is with the Bank of even larger than it is in the United States, and core inflation was well under control at 1.3% in England’s main September (latest data). Making matters worse, an acceleration in COVID cases has led to policy rate. numerous new restrictions being put back in place on U.K. households and businesses. Beyond COVID, the U.K. economy is also dealing with the continued uncertainty surrounding Brexit and the nation’s future relationship with the European Union. In an effort to provide further monetary support to the economy, the MPC on November 5 increased its asset purchase program by a larger- than-expected £150 billion to a total size of £895 billion. The MPC once again eschewed a negative policy rate, and we do not anticipate the committee taking the Bank Rate into negative territory anytime soon. But, should the MPC eventually cut the Bank Rate below 0%, SONIA could fall into negative territory as well. The European Central Bank and €STR In the euro area, EURIBOR and EONIA (Euro Overnight Index Average) have been the dominant reference rates over the past few decades. As in the United States and the United Kingdom, manipulation of surveys and declining volumes in interbank funding markets pushed policymakers Unlike in the U.S in the Eurozone to reform their key benchmark rates, culminating in the EU Benchmarks and the U.K., the Regulation (BMR). Unlike the United States and the United Kingdom, however, the primary inter- primary inter- bank offered rate in the euro area is slated to continue past 2021, as changes have been made to the bank offered methodology of EURIBOR to make it BMR compliant. EONIA, on the other hand, will ultimately rate is slated to be replaced by the euro short term rate (€STR). First published by the European Central Bank continue past (ECB) in October 2019, €STR is a volume-weighted, trimmed-mean rate based on transactions in 2021 in the euro the euro unsecured overnight wholesale market.
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