We spent the past two weeks talking about what a normal economy looks like… and how it’s all been distorted over the last 50 years or so. Even the US Treasury market – the bedrock underpinning the global financial system – is starting to crack.
As we’ve discussed, the current financial trajectory is not sustainable. But that doesn’t mean the American financial system is doomed.
If you’ll permit me, I’d like to venture into an esoteric corner of the global financial system today… and maybe even peak behind some curtains. What I’ll share with you is my analysis – the conclusions I’ve come to after many hours of careful consideration.
The Federal Reserve (the Fed) began publishing something called the Secured Overnight Financing Rate (SOFR) in April 2018 – two months after Jerome Powell became Fed Chairman. We didn’t realize it then, but the second American revolution was underway.
SOFR (pronounced “so-fur”) is a benchmark interest rate for dollar-denominated loans and derivatives. It’s based exclusively on transactions in the US Treasury repurchase (repo) market—which the Fed is directly involved in.
SOFR gradually grew in importance in the years after its creation. Then it replaced the London Interbank Offered Rate (LIBOR) as the interest rate benchmark for dollar-denominated loans and derivatives in January 2022.
Again, we didn’t realize just how significant this move was at the time. But in hindsight, SOFR replacing LIBOR liberated US monetary policy from international influences. Here’s how…
Financial institutions use interest rate benchmarks to price loans. That means interest rates throughout the economy are directly influenced by the benchmark used. Prior to 2022 it was LIBOR for dollar-denominated loans. Now it’s SOFR.
As we’ve discussed, the Federal Reserve cannot “set interest rates”. All it can do is adjust the federal (fed) funds rate. That’s the rate at which banks lend money to each other overnight.
The fed funds rate does affect the interest rate benchmarks… but it does so differently for each.
With SOFR, the fed funds rate has a direct impact. It sets a floor below which SOFR is unlikely to fall.
However, the fed funds rate did not have a direct impact on LIBOR. It only had an indirect influence.
That’s because LIBOR was calculated based on daily estimates submitted by a panel of 16 banks. That panel consisted of 11 banks headquartered in Europe… three American banks… one Japanese bank… and one Canadian bank.
However you slice it, European interests dominated the benchmark.
For this reason, the fed funds rate could not set a floor under LIBOR. Because the global banking consortium could always submit lower estimates to push rates down. And that’s exactly what they did…
In 2012 the “LIBOR Scandal” broke. We learned that some of the panel banks were submitting artificially low rate estimates to manipulate LIBOR lower.
The big takeaway is this…
When LIBOR was the interest rate benchmark here in the US, it effectively handcuffed American monetary policy to that of the European Union (EU)… because 11 European banks had an outsized influence on setting the benchmark rate.
Notice the difference between SOFR and LIBOR here. It’s critical.
SOFR is based exclusively on transactions in the repo market. These are real transactions that have occurred. Contrast that with LIBOR… which was based on estimates submitted by a panel of banks – not actual transactions.
We’ll talk about why that’s so important tomorrow…
-Joe Withrow
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