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Good afternoon,

The UK and EU finally came to an agreement on Northern Ireland, and so did consensus on Eurozone and APAC inflation after the week of economic data – not great. The overall reading for EU inflation came in hotter than expected this morning at 8.5% (prev. 8.6%), with core inflation accelerating to a record 5.6% (prev. 5.3%).

The S&P just logged its third-worst month since your MD’s newest girlfriend has been alive – give or take 25 years. The 1-Year US Treasury now pays 3x higher than the dividend yield on the S&P 500 (~5%). 

Let’s dive in.

Economy Heat Check

As of 3/1/2023 market close, unless otherwise stated.

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Briefings

• China's factory activity expands at its fastest pace in over a decade (Reuters)

• Paramount said to turn down a $3B offer for Showtime (WSJ)

• Virgin Galactic confirms launch date of commercial spaceflight service (Yahoo)

• Rivian Automotive slumps after production guidance disappoints (Barron’s)

• General Motors cut jobs despite pledges to the contrary (CNBC)

• Goldman Sachs CEO David Solomon took the podium at its investor day yesterday, but his lack of answers saw the stock dive 4% by the end of his presentation (BBG)

Expectations Reset

The week in review.

US Consumer debt is now above levels hit during the 2008 financial crisis. To summarize alarmist news anchors: 

• Household debt hit a record $16.9T

• Credit card debt hit a record $986B*

• Mortgages hit a record $11.9T

• Auto loans hit a record $1.6T

• Student loans hit a record $1.6T

Not to be outdone, real wages are down after rising for the better half of a decade, meanwhile the savings rate is plummeting.

If it’s any consolation: debt service payments as a percentage of personal income have been rising, but remain near the lowest levels in the last 43 years (FRED). In other words, the ability to service debt remains very favorable by historical standards.

* Despite fear mongering, credit card debt as a percentage of GDP (roughly $26T) is about 3.5%, which is below the average for the 2010s decade.

The ECB is beginning to see its latest inflation data this week, with experts correctly predicting another strong core reading despite predictions of a softer headline number. Notable prints included: 

• Spain’s CPI inflation for February rose to 6.1% year-over-year (est. 5.9%; prev. 5.9%).

• France’s CPI inflation for February rose to a record-high 6.2% year-over-year (est. 6.1%; prev. 6.0%).

The inflation print is expected to cement the ECB's plan to raise rates by another half-point next month. 

U.S. durable goods orders plunged to -4.5% in January (exp.) — their biggest monthly drop since Covid lockdowns in 2020.

Some analysts are calling the report a head fake, given ex-transportation, durable goods orders rose 0.7%, the highest since March 2022. Conspiracy theorists are taking it a step further and saying the manufacturing sector is defying purchasing manufacturing’ reports that suggest weakening. 

If believed, good news is bad news as it means more rate hikes. That conclusion is a shocker.

Pending home sales rose by 8.1% in January, crushing previous expectations of 1% (prior -1.1%). It marks the best month since June 2020. Don’t get all Jim Cramer bullish on us quite yet. Mortgage rates are back up and applications are down, hinting at weakness in the coming weeks for home sales

Home prices in the US declined for a sixth straight month, sending a key index of values down 2.7% from its peak in June (Case Shiller National Index). The 4.4% decline over the last 6 months is the largest 6-month decline since 2011-12, but prices are still 39% higher than they were 3 years ago.

The US Consumer Confidence Index fell from 106.0 to 102.9 in February, well below expectations. Despite the reading, the labor differential (i.e. those who say jobs are plentiful vs. hard to get) rebounded further. If this relationship holds, it implies wage growth stays strong for a while.

Jumping on any sign of positive news or press, Treasury Secretary Janet Yellen just declared “so far, so good” on the inflation battle yesterday. The US has now seen 5%+ inflation for 21 consecutive months. In other words, even if inflation comes down next month, it’s not nearly as fast as investors are hoping.

With the next US CPI report due March 14th, current predictions have inflation decreasing to 5.9% (from 6.4%), with core CPI at 5.4% year-over-year (from 5.6%).

DEEP DIVE: Lie-bor 

A rogue trader rendered banks’ benchmark useless, but $1T of risky US loans remain shackled to it.

Here’s what you need to know about the looming deadline to transition to SOFR from LIBOR.

An Econ 101 Background

LIBOR (London Interbank Offered Rate) is being phased out and changing to SOFR (Secured Overnight Financing Rate). You may recognize it from our table at the beginning of each newsletter – that’s because it’s a daily rate many bankers, especially those in credit, care about. 

LIBOR has been the most widely used benchmark interest rate for financial contracts, such as loans and derivatives, since the 1980s. That all changed after a rate-fixing scandal in 2012. Naturally, concerns about the reliability and accuracy of LIBOR then arose. It was discovered that some banks had been manipulating the rate to their advantage.

Here’s who you have to thank for the change, and why it matters today. 

The Rate Fixing Scandal

Enter Tom Hayes, the most irrelevant British banker to become famous overnight since Nick Leeson. Hayes is a former trader who worked in the financial industry for several years before being convicted for his role in the LIBOR rate-fixing scandal.

Hayes began his career in finance in 2001, working as a trader for Royal Bank of Scotland (RBS) in Tokyo, where he traded interest rate derivatives. He later moved to UBS, where he continued to trade interest rate derivatives and became a director of the bank's Tokyo office. In 2009, he moved to Citigroup, where he also traded interest rate derivatives.

The promotions boiled down to something Hayes noticed early in his career. Like most bankers, Hayes was looking for ways to profit more from his trades. The only problem was, he got Elizabeth Holmes-creative. 

During his time at UBS and Citigroup, Hayes realized he could manipulate the LIBOR rate to profit from his trades. He would simply submit false information about the interest rates his bank was being charged for borrowing money, which would then affect the LIBOR rate. When the rate changed, his trading positions benefitted. 

Some quick math on the impact: Mis-pricing 800T of notional principle leads to some very large numbers. Numbers large enough to trigger debate and get the Fed’s attention.

So, in short, Hayes conspired upwards in his Libor-rigging all the way to the director level at Citigroup. At Citi, he continued to submit artificially low or high rates in order to benefit his own trading positions. 

Though Hayes took advantage of the press that came his way amidst the trial, citing he was scapegoated, our lack of "allegedly" is because he was, you know, convicted. The size and volume of his trades, his communications with other traders, and his persistence in manipulating the rate over a period of years, made it easy enough that even Chuck Rhoades could convict him.

That’s how Hayes ended up arrested in December 2012 and charged with eight counts of conspiracy to manipulate LIBOR. He was convicted on all counts in August 2015 and sentenced to 14 years in prison (later reduced to 11 years on appeal). 

We couldn’t find him on LinkedIn, but you can try to coffee chat with him – he was released in 2020. 

The Global Response to the Scandal

In response, global regulators decided to phase out LIBOR by the end of 2021, and replace it with more “reliable and transparent” benchmark rates, such as SOFR. SOFR is based on transactions in the US Treasury repurchase market and is considered to be a more robust and accurate measure of short-term borrowing costs than LIBOR.

The transition has been a complex process. It means contracts, systems and processes across the financial industry all need to be updated. And banks have certainly been having their fun making that effort known and felt to regulators. But according to the Fed, the transition was necessary to maintain “the integrity and stability of the financial system.” 

In less political jargon, the transition is supposed to ensure that benchmark interest rates are reliable and transparent.

Who the Change Impacts 

About 75% of the U.S. leveraged loan market still needs to transition away from LIBOR. With LIBOR expected to end on June 30, 2023, there are plenty of legal and financial implications to consider. That means the pace of remediation of leveraged loans (and other commercial loans) needs to hurry up.

Some of the LIBOR-based financial instruments affected by the transition include:

• Existing loans transitioning to a replacement benchmark

• Existing caps/swaps that should transition to the same replacement benchmark of the associated loans (but often remain unchanged); caps/swaps will transition to a different benchmark on the LIBOR end date absent proactive borrower efforts

• New loans utilizing a new benchmark

• New caps/swaps utilizing a benchmark different from the associated loans

In the urgency to transition, these are expected to have significant financial impacts that have yet to be recognized.

The Financial Fallout for Banks 

As of January 10, 2021, the twenty largest U.S. bank holding companies had around $2T of credit line commitments, of which approximately $1.5T were committed but remained undrawn. Over two years later, roughly three-fourths of the $1.4T US leveraged loan market still needs to flip to SOFR to meet its transition deadline.

So, a fight between lenders and borrowers in the US leveraged loan market has slowed down the Libor transition. Even though the deadline to phase out the benchmark in existing corporate loans is inching closer.

So Why Haven’t Banks Transitioned? 

Banks and lenders recently rejected a string of amendments that would have flipped the benchmark on some existing loans. They’re haggling over what’s called a “credit spread adjustment.” Basically, it accounts for the differences in risk between LIBOR and SOFR.

LIBOR is an unsecured lending rate, meaning that it is based on the rate at which banks are willing to lend to each other without any collateral. SOFR, on the other hand, is a secured lending rate, so it is based on the rate at which banks are willing to lend to each other using collateral, such as US Treasury securities.

The underlying collateral is different, so there is typically a spread between the two rates. The credit spread adjustment is meant to account for this spread by adding an appropriate amount to the SOFR rate to make it comparable to the LIBOR rate. And, naturally, banks are going to make sure that adjustment is in their favor. 

The credit spread adjustment is important because it helps to ensure that contracts that are currently based on LIBOR can be transitioned to SOFR without disrupting the financial markets. Without the adjustment, economists anticipate significant differences in the interest rates used in different contracts. That would lead to confusion and even more legal disputes.

What’s Next in Cartel Litigation 

The transition, or at least the news surrounding it, couldn’t come sooner for some banks looking to avoid any more limelight. 

Banks have paid billions in total to make the Libor manipulation allegations go away—at times in nine-figure chunks, at others in increments of a few million dollars. Some recent or ongoing cases focus on benchmarks involving the currencies of Singapore, Japan, and Australia.

The most recent Libor case is part of a wave of cartel litigation stretching back more than a decade. It takes aim at overlapping schemes by major financial institutions to, similar to Hayes, manipulate critical interest rate benchmarks that drive global banking and trade.

Last week, Credit Suisse, Deutsche Bank, and NatWest stepped closer to exiting antitrust litigation over their own roles in Libor manipulation. The banks just agreed to settle for a combined $47.75M. NatWest will hand over $21M, Credit Suisse is shelling out $13.75M, and close behind is $13M from Deutsche Bank. 

TL;DR - If you weren’t recently charged with interest rate manipulation, expect the transition to increase expected borrowing costs on revolving lines of credit. In other words, going from a credit-sensitive reference to a risk-free one will have its costs. 

But hey, it was the Fed’s decision. So just do what you’ve been for the past two years and thank Jerome Powell. 

STILL TO COME: Eurozone PPI & PMI

The Eurozone recovery accelerated in February, if you’re to believe the PMI data for January. Supply chain problems are lessening, and so is the supply situation for Eurozone companies. 

Sentiment about the eurozone economy declined very slightly from 99.8 in January to 99.7 in February according to data out on Monday. Albeit stable, but not indicative of an economy strongly bouncing back.

The ECB reported a €1.6 billion operating loss last year – its first in 18 years. As a result, the central bank has scrapped its dividend. National central banks in the Eurozone will report finances in the coming weeks, many already warning of losses. 

The economic sentiment indicator for February seems slightly less optimistic than the PMI, experts report. With the hiking cycles of the ECB and BoE likely to diverge very soon, the Pound could start to show relative weakness unless data really starts to pick up and the BoE stays hawkish.

TL;DR - The broad Euro picture that remains is one that shows an economy still struggling with high inflation but profiting from fading supply-side problems. This leaves economic growth around stagnation for the winter months.

Meme Bank

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