There’s no solace in this current environment. We are facing one of the most devastating economic outlooks in our lifetime. Amidst it all, the policies of the Federal Reserve and central banks globally have come back front and center. Many programs are from the 2008 playbook, but the most significant are new as we are faced with unprecedented dynamics.
Interest rates are the underpinnings of valuations within global capital markets. Yet, at the same time and since the 2008 crisis, the pathway that central banks have embarked on have been controversial. From negative interest rate policies oversees which have clearly not worked if judging by economic growth, to the Federal Reserve in the United States which began raising rates too late. The London Interbank Offered Rate has been equally, if not more, controversial. The LIBOR versus SOFR conversion is front and center amidst the covid-19 uncertainty.
The Fed runway has been long
When looking at the chart below: S&P, Federal Reserve Balance Sheet and Effective Federal Funds Rate, it is hard to not see the “easy money” influence on risk assets. It is also not difficult to envision a scenario where risk assets take another leg lower amidst the economic reality brought on by the coronavirus. From 2001 – 2006 and 2010 – 2015 rates were kept low, for too long. Interest rates will now once again remain low for a very long time and for different reasons. Unlike prior periods, the consequences for risk assets remain more uncertain.
The Federal Reserve
We strive to offer a balanced view of the Federal Reserve. In the end, as an institution, there have been many different leaders and mindsets over time. Within this most recent pocket of time, the Fed has been very active in utilizing the Federal Reserve Act in conjunction with both the Department of Treasury and with changes in the Dodd-Frank Act. The Federal Reserve Act allows the Fed to be the lender of last resort, more specifically, “in unusual and exigent circumstances.”
It is difficult in this window of time, with all the acronyms, to ignore SOFR. It is clear the Federal Reserve wants SOFR to replace LIBOR but market, end user opinions and behavior matter in this environment.
The secured versus unsecured debate
In the end, this is no longer a debate. To a large extent, LIBOR has done what it’s supposed to do; widen when unsecured rates widen. The below charts highlight some of the dynamics within the covid-19 crisis. Specifically, the flight from prime money funds into government funds with the overall pool of cash still growing. In addition, the behavior and widening of secured/unsecured (LIBOR/SOFR spread) versus the Five-year Investment Grade CDS Index. Additionally, the outright chart on three-month LIBOR coincides with the bottoming of the prime funds and implementation of the Federal Reserve’s Commercial Paper program in the middle of April.
Money market funds overall growing versus declining prime funds