Top of the Street: The waiting game, farewell LIBOR, new rules for hedging, a peak in credit card losses and more

We’re back from a busy start to this week. Markets seem to be waiting for December. LIBOR heads for the door. The accountants change the rules for hedging. Credit card losses hit a 4-year high. And more. Contributions from JPM, Nomura, S&P, WFC and Milepost.

Markets: A waiting game
It’s only August, and already all eyes are on December. Sure, the Fed should announce in September an October start to trimming its portfolio. Then the market will have to wait until December to see if the Fed gets enough inflation to hike again. The market for now gives a December hike only a 39% chance. Only by March 2018 does the cumulative chance of a hike rise above 50%. This seems to discount the possibility of material tax reform or problems around the US debt ceiling or any missteps in trimming the Fed’s portfolio. The likelihood of material surprises there do seem low. The MOVE index of implied future interest rate volatility set record lows in July. Rates do seem to be on a low and steady path. But the price of insurance has never been lower. Position for low and steady rates, but insure. (Milepost).

Markets: Farewell to LIBOR
If the top UK financial regulator gets his way, one of the world’s most influential interest rate benchmarks will go the way of the dinosaur by 2021. Andrew Bailey, head of the UK Financial Conduct Authority, announced last week a plan to phase out the London Interbank Offer Rate or LIBOR currently used to set rates on more than $160 trillion in instruments from mortgage loans and bank loans to floating-rate debt and interest rate derivatives. LIBOR has suffered in recent years from a lack of active unsecured short-term lending between banks, driven by new regulations that encourage banks to find longer and more stable funding. Thin interbank lending has forced banks that help set LIBOR to rely more on judgment than on actual transactions. The substitute for LIBOR in the US looks likely to be the Broad Treasuries Financing Rate or BTFR, an overnight rate for lending against Treasury debt calculated from the deep and active tri-party and other repo markets. BTFR would be an entirely new benchmark, however, and will not be published by the Fed or Treasury until the first half of 2018. Parties to transactions that rely on LIBOR may have to scramble to find a substitute since LIBOR and BTFR are materially different – LIBOR an unsecured rate and BTFR secured. Contracts for Fannie Mae mortgage loans and securities, for instance, specify that if LIBOR is not available, the note holder will choose a new index that is “based on comparable information.” Fed funds might be a plausible substitute. Although markets should have years to work through any issues created by the LIBOR sunset, the size and long maturity of the affected markets ensure lots of work ahead. See JPMorgan, US Fixed Income Markets Weekly: There is no “i” in Libor: Benchmark reform gets a deadline, 28 Jul 2017. See also Nomura, The End of LIBOR: Potential impact on Securitized Products, 28 Jul 2017. (JPM, Nomura, Milepost).

Markets/banking: An accounting change may help managers of MBS
The latest accounting rules for instruments used to hedge risk may help banks and other holders of MBS. Accounting Standards Codification Topic 815, finalized in June, allows investors to split MBS into a first layer expected to be buffeted by prepayments over the life of the asset and a last layer expected to be largely immune. Stress scenarios with fast prepayments can help identify the last layer. Changes in the value of any hedges would offset changes in that last layer in an investor’s periodic accounting statements. This is a big change from current rules, which usually leave changes in most MBS hedges flowing through quarterly income while changes in asset value flow through shareholder equity. The new rules, effective December 15, 2018, could encourage banks to hedge some of the $1.1 trillion in MBS held in available-for-sale accounts and some of their $2.1 trillion in mortgage loans. Banks would likely pay the fixed leg of interest rate swaps and receive the floating leg. This could trim bank demand for floating-rate debt. See JPMorgan, US Fixed Income Markets Weekly: Absolutely FASBulous: Reviewing the implications of recent changes to hedge accounting standards, 28 Jul 2017. See also Wells Fargo, Agency MBS Weekly: New Accounting Rules and MBS Investing, 28 Jul 2017. (JPM, WFC, Milepost).

Markets: Following the corporate cash
Corporations continue to use banks as a favorite place to park cash, according to the latest annual survey of corporate treasurers by the Association of Financial Professionals. Corporations put 53% of their cash in banks, down slightly from recent years but twice the rate of 10 years ago. Government money market funds capture only 14% of corporate cash. Although only 4% of the cash goes into separately managed accounts, nearly a third of the 683 respondents (31%) signaled that they are looking at the possibility. See JPMorgan, Fixed Income Markets Weekly: Short-Term Fixed Income, 28 Jul 2017. (JPM, Milepost).

Markets: Credit card losses hit 4-year high
The average net charge-off rate for large U.S. credit card issuers increased last quarter to a 4-year high, according to S&P. Credit card losses have increased YoY for five straight quarters. A period of very low charge-offs started after credit card lending tightened in 2010, but lenders started loosening in 2014. “The overall environment is deteriorating,” says Discover Card’s David Nelms. Losses nevertheless remain well below historical levels. According to Charles Peabody from Compass Point Research & Trading LLC, however, there has been an inflection point in credit and things will “get worse from here.” S&P has also forecast an increase in charge-offs under all economic scenarios over the next couple of years. (S&P, Milepost).