The First Storm of the Economic Fall (1)

 As I commented before, there are a series of economic factors that suggest that we would be facing a seasonal change in relation to the world economy. Something like the fall of the financial system (see article). The actions of central banks appear to be increasingly focused on adjusting to extraordinary and unprecedented conditions.

On June 30, 2023, the first storm of the economic fall may begin to form. This is due to the implementation of SOFR (Secured Overnight Financing Rate), replacing LIBOR (London Interbank Offered Rate). You can see the countdown here.

LIBOR has been the reference rate for large banks that need liquidity in transactions between banks, the so-called Repo market. For almost four decades, the Intercontinental Exchange (ICE) in London has published LIBOR's 35 daily rates, based on five exchange currencies, the US dollar, the euro, the British pound, the Swiss franc and the Japanese yen, with different maturity rates.

LIBOR rates issued daily impact credit interest rates around the world. In addition, LIBOR has been the rate at which more than 220 trillion dollars in financial derivatives are valued.

The reasons why LIBOR is going to stop being relevant, even though it continues to exist, is due to its unreliability when establishing rates, since these are estimated in the future with complex analyzes and algorithms, based on data from a limited number of transactions, a model that is not always realistic. Added to this are some rate manipulation scandals that benefited large banks over the past decade.

Unlike LIBOR, the creators of SOFR have built in insurance to prevent large rate swings from negatively affecting the market by collateralizing US Treasuries, which means that if there are negative swings, the insurance will take effect, giving more peace of mind to the market and reducing risk.

The change that is generated is also geopolitical, from London to Washington D.C., from a basket of five currencies to the dollar and the United States Federal Reserve.

The problem raised may not be so obvious, but it is relatively simple to explain.

There are trillions of dollars in issued credits and financial derivatives whose rates have been defined and calculated according to LIBOR. With the entry of SOFR, all these credits and financial vehicles will have to be recalculated, which is not easy and will cause volatility, especially in the financial derivatives market.

When we talk about derivatives we must express ourselves in quadrillion dollars of valuation, with a leverage of 1000 to 1. A small variation between interest rates will mean a lot of money that someone will have to cover.

When the situation requires it, the Federal Reserve of the United States will have to cover the difference generated by the unadjusted rates, which means it will have to create large amounts of liquidity, that is, printing dollars. In the medium term, this will generate inflation, which would drive an increase in rates, in something that could become a vicious inflationary / deflationary cicle that, following the example of the storm, could get us all soaking wet.

Blessings,

Luis Leighton