Let’s give this libor can a kick
December 1, 2020
The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (collectively, the agencies) are issuing this statement to encourage banks to transition away from U.S. dollar (USD) LIBOR as soon as practicable. 1 Background and Discussion The FFIEC’s “Joint Statement on Managing the LIBOR Transition”2 noted that the LIBOR transition is a significant event that banks should closely manage. The FFIEC statement further explained that new financial contracts should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation. Separately, the agencies recently issued a statement that says a bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs. 3 The administrator of LIBOR has announced it will consult on its intention to cease the publication of the one week and two month USD LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining USD LIBOR settings immediately following the LIBOR publication on June 30, 2023.
–The announcement above caused significant turmoil and position adjustment on the euro$ curve. Contracts from EDH’22 thru EDM’23 exploded higher (+4 to +5.5) as the ‘libor fallback’ was apparently extended to the end of June 2023. This adjustment was most notable when looking at the ‘old’ libor fallback trade when participants expected libor (thru previous guidance) to end at the end of 2021 vs the ‘new’ libor fallback. The old trade was EDZ’21/EDH’22 calendar spread which went from +4.0 to -1.0 (Z1 9976s, +0.5 and H2 9976.5s, +5.0). Huge one-day move for a 3-month calendar! The new spread is EDM’23/EDU’23 which jumped 3 bps from 4.0 to 7.0 (M3 9964.0 +4.0 and U3 9957.0 +1.0).
–It’s somewhat ironic that the Fed minutes from November repeatedly mentioned the restoration of “smooth market functioning” as a goal of emergency covid funding measures, and then they drop this bomb. I guess the market did adjust in an orderly way on large volume, though I don’t think the pnl was particularly smooth for some players. For example, remember the massive sales of EDZ2 9962.5c at 11 when the contract was trading 9963.0? The contract settled yesterday at 9970 (+4.0) and those calls at 15.75 (+3.25). The other large position that was partially exited is the EDH2, EDM2 and EDU2 9975/9962p 1×2’s. There had been a buyer of the 1×2’s, buying the 9975 and selling 9962 twice, crushing the lower strike across the reds. Here’s how the settlements changed yesterday:
–EDH2 9975p fell 2.5 bps from 7.75 to 5.25, while 9962p were unch’d at 2.0. The 1×2 went from 3.75 to 1.25.
–EDM2 9975p fell 3.0 from 10.25 to 7.25, while 9962p ROSE 0.25 to 3.25. The 1×2 went from 4.25 to 0.75!
–EDU2 9975p fell 3.75 from 12.5 to 8.75, while 9962p fell 1.0 to 4.5. The 1×2 went from 1.5 to -0.25.
That, as they say in the business, is gonna leave a mark.
–So while EDU2 9962.5 straddle had been settling around 17 the past several sessions, it settled 20.5 yesterday and the new atm 9975^ settled 16.5 with 659 days to go.
–The contract with the largest change in open interest was the ‘new’ end of libor contract, EDU’23, which added 36.5k contracts. It might be considered a coincidence that last week the EDU’23 puts became a bit more active, with a buyer of the 9950/9900 put spread for example. Not large enough to be egregious, and actually not a winner unless done hedged. I’m just saying there are some people out there with *ahem* better information than others.
–This morning we have ESZ0 at all time highs and Nasdaq knocking on the door as stocks only go up. Dec bitcoin is above 20k, and even gold has joined the party, with GCG1 rebounding $27 off the lows to trade 1808.
–Powell testifies today in front of Senate Banking. Perhaps the libor switcheroo will come up. Certainly the topic of a fiscal lifeline will be emphasized.
–One last note, the ten year treasury to tip breakeven closed at a new recent high of 179.5 bps. The high of the year has been just above 180, which occurred right at the start of year and again in August. Third time’s a charm. This is sometimes considered a proxy for long-term inflation expectations. While Fed officials continue to emphasize deflationary risks, the market is telling a slightly different story, while keeping an eye on USD weakness; DXY made a new yearly low yesterday and is currently 91.72.
