I have always been impressed with the notion that accounting can be as much of an art as a science. There is so much that is open to interpretation and creativity. While there are some authoritative standards, there are also a fair amount of practices that are commonly accepted which has given way to the doctrine of GAAP, also known as Generally Accepted Accounting Principles. It struck me that we may have reached a similar state in Central Banking known as GAMP or Generally Accepted Monetary Principles. What seemed like unconventional and bizarre monetary policies in the immediate post-crisis world, have come to look generally accepted, if not pedestrian. The tools deployed over the past decade are no longer temporary, but are now a permanent part of a Central Banker’s tool kit. How did we get here? What are the risks? What does this mean for investing in the markets? These are all good questions, but I want to go back in time and get a running start into this discussion!
It used to be that monetary policy was all about interest rate targeting. Set the correct deposit rate and watch it ripple across the yield curve into the funding cost of any borrower and the opportunity cost of any saver. If a central bank wanted to lean against growth and inflation from running too hot – raise rates. If they wanted to promote growth and inflation – cut the deposit rate and relieve some of the pressure with a lower funding cost across the ecosystem. With just one straight-forward tool, I remember when the Federal Reserve (Fed) would move interest rate targets around based on how it wanted to prioritize growth, inflation and the dollar. Life for a central banker was so simple back then….although the markets were arguably quite a bit more volatile.
Fast forward to the Great Financial Crisis and suddenly new tools were needed with far greater capabilities than only moving deposit rates around. Quickly ZIRP (zero interest rate policy) and QE (quantitative ease) became part of the central banker tool kit. When first implemented outside Japan in the wake of the crisis, money printing at a cost of 0% in order to buy government bonds was seen as extreme, unconventional and certainly only a temporary policy tool. The distortions to markets grew as ZIRP transformed into NIRP (negative interest rate policy) and purchases extended to mortgages, corporate debt and equities (in the case of the BOJ). It was reasoned that unless these tools were temporary, significant inflation bubbles would form.
But that has not happened. These tools are still present, but the bubbles are not. There is a combination of denial, confusion and anger about their lingering existence and potential longer term impacts. In fact, I just met with a former central banker who still decries their very existence, despite much evidence that suggests that they have helped the recovery and done little of the harm that was originally advertised.
With the unconventional policy now proving to be eternal, we believe that we have entered a new, modern world of central banking defined by GAMP….Generally Accepted Monetary Principles. Not only have central bankers embraced these tools as permanent, but they have begun to experiment with newer ones. The Fed has opined on inflation targeting through a cycle whereby core inflation could run above the 2% target during an expansion to make up for ‘lost’ inflation during recessions. In fact, to truly make up for lost inflation since 2007, core PCE would need to run at 2.5% for the next 9.5 years! In this context, the bar for additional rate hikes should be quite high in this cycle. And, if the Fed doesn’t like the message a potential inversion of the yield curve is sending to the markets, they now have the ability to manage the balance sheet run-off and subsequent reinvestments to influence the curve. Why not Quantitative Tightening (QT) on the mortgage holdings and Quantitative Ease (QE) on the front end of the Treasury curve? Essentially, their own version of operation reverse twist.
Permanently adopting these new tools is not only limited to the U.S. and the Fed. The European Central Bank (ECB) has indicated that it might be open to tiering of the official deposit rate – a mechanism to help mitigate the impact of negative interest rates on financial institutions. Throw in another round of Targeted Long Term Repo Operations (TLTRO), Optimal Yield Curve Control in Japan, and Currency Intervention etc…..suddenly, the definition of Generally Accepted has changed forever.
Listed below are examples of new tools that have been deployed since the financial crisis, and by whom:
To be fair, this is not the first time some of these “unconventional tools” have been deployed, although the intent and motivation of past central bankers was unique compared to more recent times. In the 1960’s, the Federal Reserve and U.S. Treasury engaged in ‘Operation Twist’ to keep long term borrowing rates low and encourage investment while also attempting to discourage capital outflows and the impact to the dollar due to potential gold outflows. From 1931 to 1937, the Swedish Riksbank became the first central bank to explicitly introduce price level targeting when it was relieved of its legal obligation to convert its notes into gold on demand and was struggling with deflation and an economic depression. The regime was not long lived because following the depths of the depression and the start of World War II (WWII), the central bank once again became subordinate to fiscal policy initiatives. Similarly, in the U.S. between the 1940’s and 50’s, the Federal Reserve periodically intervened in the long-term Treasury market by using interest rate pegs to lower borrowing costs in order to fund wars. While the buying of debt directly from the Treasury was prohibited at the time, an amendment to this rule was made during WWII allowing for a $5 billion wartime exemption.
Are there risks to unconventional tools becoming mainstays of monetary policy? Almost certainly if they are not properly used. The list of consequences if policy tools are used inappropriately or are no longer in the hands of an independent influence is long and concerning: asset bubbles may form, inflation may surge and the moral hazard of the end to fiscal discipline is a very real possibility. The current fascination with Modern Monetary Theory (MMT) highlights the fragility of GAMP if a certain version is finalized ……with emerging economies being referenced as the poster child for how it all ends in tears. On the other hand, Japan is an example of how another version of GAMP can be used over an extended period of time without grave consequences. I know the debates here are endless (I’ve had my fair share over the last month) and each economy has its own particular circumstances which allow versions of GAMP to succeed or fail.
Most important for us as investors is to welcome GAMP and the new tools being broadly deployed as part of the principles of unconventional policies becoming conventional. Essentially, these policies are not going away and we must understand and embrace the opportunities these policies create in the markets wherever they may occur. Yes, I would have liked the Fed to keep raising rates to 3%, to run down its balance sheet for another couple years, for the ECB to move deposit rates back above 0% and run down its balance sheet, and for the BOJ to start its own version of normalization. It would have likely meant that we could all be investing at much higher yields instead of the paltry levels we’re left with today. But it didn’t happen and central bankers have correctly recognized this is not the time to push recklessly towards these outcomes of more “normal” policies. On the contrary, the central banks are telling us that where we are today is now normal. With the pressure of further normalization now eliminated and the global expansion likely to continue as a result, investing in risk assets makes sense especially as the focus on future growth and inflation has shifted to fiscal policy.
I, for one, embrace the new GAMP. I applaud the willingness of central banks to experiment in an effort to moderate a significantly larger and more complex global ecosystem. I have my own views on which tools are more effective or ineffective, but ultimately I need to tie that back to investment drivers and opportunities. I encourage all investors to stop burning time and energy fretting about the new central banker GAMP doctrine, and instead interpret, model and study them in an effort to generate better returns.
Market participants can no longer ignore the elephant in the room – that the secular decline in interbank short-term funding poses serious structural risks for unsecured benchmarks, such as LIBOR (the London Interbank Offered Rate) and its relatives (GBP LIBOR, USD LIBOR, Euro LIBOR, CHF LIBOR, JPY LIBOR and EURIBOR/EONIA). Below, we take stock of the current status of IBOR changes, key challenges to the transition for investors, and turning points ahead as we edge ever closer to a world without LIBOR.
How we got here:
The impetus to establish more transparent and robust risk-free reference rates stems from post-crisis concerns about the level of daily transaction volumes in existing interbank funding markets. For example, there are less than $500 million of daily transactions, on average, in a $200 trillion USD LIBOR market. A 2014 white paper released by the Financial Stability Board (FSB) on the reform of interest rate benchmarks spurred global preparations to transition away from IBORs (interbank, quote-based reference rates) to a range of largely transaction-based risk-free rates (RFRs). The transition could affect some $370 trillion worth of derivatives and floating rate securities linked to LIBOR. Add to the existing confusion a set of global regulators with independent, differentiated approaches to the transition and the situation becomes quite a bit messier.
So what are the key challenges facing markets ahead of the transition?
Where are we now?
Working groups have established preferred alternatives for GBP, USD, JPY LIBOR, EURIBOR/EONIA, and CHF LIBOR, and consultations are underway to assess implementation processes for the various jurisdictions.
In the United Kingdom, the Bank of England (BoE) began publishing a reformed version of SONIA (Sterling Overnight Index Average), an unsecured overnight borrowing rate, in 2018, and has chosen it as an alternative to GBP Libor.
Separately, the European Benchmarks Regulation (BMR) will now take effect on January 1st, 2022, and will force EONIA (Euro Overnight Index Average) out of existence, and require EURIBOR (the term rate similar to EUR LIBOR) to be reformed.
In the United States, regulators have identified the SOFR as a preferred alternative for USD LIBOR. The New York Federal Reserve began publishing SOFR in 2018.
Futures for both SOFR and SONIA began trading in 2018. Daily trading of SONIA and SOFR futures and overnight indexed swaps (OIS) will continue, which should promote liquidity in these nascent markets.
The International Swaps and Derivatives Association (ISDA) working group released a final report at the end of 2018 on feedback for the preferred method of converting OTC derivatives to new RFRs on the day of transition. The report showed a preference for a compounded, setting in arrears rate and the use of a historical average for calculating the spread adjustment between LIBOR and the new RFR at transition.
Separately, the BOE has released preliminary results of its consultation on TSRR (Term Sonia Reference Rate), focusing on the GBP LIBOR transition to SONIA. The consultation explores various use cases for a term reference rate in order to address the term structure needs of GBP FRN users.
Regulators have encouraged transition to the use of SONIA for new Sterling denominated bond issuance. In 2018, seven covered bond issuers and Supranational, Sub-sovereign, and Agency (SSA) firms issued Sterling-denominated SONIA FRNs; all were well received by the market, and experienced solid subscription levels. This increased issuance has continued apace this year, with twice as many SONIA-linked bonds issued as last year already. The successful issuance suggests reason for optimism that issuers and investors are working proactively to prepare for the transition. Investors should expect new issuance referencing alternative RFRs to persist going forward.
What will the transition mean for investors?
The Financial Conduct Authority’s (FCA) Andrew Bailey warned market participants that they should wholeheartedly prepare for the discontinuation of LIBOR at the end of 2021, noting that the transition is not merely a ‘black swan event.’ The Governing Council at the European Central Bank will begin publishing the Euro Short-Term rate (€STR), the preferred replacement for EONIA, in October 2019, with the EU BMR now slated to take effect January 1st of 2022, eliminating EONIA and the current form of EURIBOR. The European Money Markets Institute (EMMI) released feedback from a second consultation regarding a reformed hybrid methodology for calculating EURIBOR at the beginning of February – EMMI has noted that it will begin transitioning panel banks to this new methodology before the end of 2019. Given the results of the ISDA consultation on a fallback methodology for OTC derivatives released at the end of 2018, the group must now focus on the implementation of these terms across the IBORs. 
In short, preparations are well underway for IBOR’s termination, but much remains to be decided as we approach the date(s) of transition. While a full picture of the post-IBOR world is not yet fully formed, it is vital that investors continue to track developments of the transition, and engage actively with regulators and market participants – so watch this space for more.