{"id":112577,"date":"2022-04-14T09:39:17","date_gmt":"2022-04-14T13:39:17","guid":{"rendered":"http:\/\/stateofthenation.co\/?p=112577"},"modified":"2022-04-14T09:39:47","modified_gmt":"2022-04-14T13:39:47","slug":"sofr-vs-libor-the-raging-financial-war-between-europe-and-the-united-states","status":"publish","type":"post","link":"http:\/\/stateofthenation.co\/?p=112577","title":{"rendered":"SOFR vs. LIBOR: The Raging Financial War Between Europe and the United States<\/b>"},"content":{"rendered":"

SOFR v. LIBOR: <\/strong>Have We Been Missing Something About the Fed\u2019s Upcoming ‘Policy Error’?<\/em><\/h1>\n

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by Tom Luongo
\nGold Goats ‘n Guns<\/a><\/p>\n

The Fed is now firmly committed publicly to a very aggressive rate hike cycle in 2022 and possibly into 2023. It started with the now erstwhile hawks on the FOMC who all got pushed out during last year\u2019s \u2018insider trading\u2019 scandal.<\/p>\n

It\u2019s continuing today as FOMC Chair Jerome Powell, almost immediately after the ink was dry on March\u2019s anemic 25 basis point raise began ratcheting up the hawk talk in a clear signal to markets that seven quarter-point raises this year won\u2019t be nearly enough to restore the Fed\u2019s credibility with capital markets.<\/p>\n

All last year I kept telling you that there was a major internal battle happening for control over the Fed in order to stop the \u2018policy error\u2019 of raising rates into a supply-constrained cost-push inflation cycle.<\/p>\n

I won\u2019t rehash all the twists and turns of this story today because the fact that we are here with Powell as Chair pro-tem, still awaiting a proper confirmation hearing is the one thing you need to know that proves that correct. The Democrats continue pushing outright communists onto the FOMC board like Sarah Bloom-Raskin to replace the scalps taken last fall to forestall Powell\u2019s actual confirmation.<\/p>\n

Powell absolutely wants to make Monetary Policy American Again, after fifty years of Eurodollar markets setting monetary policy for them. As Jeff Snider so painstakingly has proven to us, the Eurodollar system is more powerful than the Fed in creating dollars and pricing the risk of those new dollars.<\/p>\n

With a sympatico Congress that never met a spending bill it couldn\u2019t compromise it\u2019s way to betraying the American people with, for decades we\u2019ve seen nothing but rearguard actions by the Fed when it tried to normalize interest rates.<\/p>\n

The failure to pass Build Back Better was the watershed moment for us here in the US. Without it, a Powell-led Fed was free to eventually end QE and begin raising rates. It needed time in 2021 for the inflation narrative to outrun the COVID-19 narrative. Once the latter ended the political support for BBB vanished and Powell was free to begin the tightening cycle.<\/p>\n

Because we\u2019ve been so conditioned to the Fed caving in the past we\u2019ve come to expect it as\u00a0de rigeur<\/em>\u00a0they will cave again. This is why there was so much disbelief leading up to the March meeting that the Fed would actually raise rates.<\/p>\n

The typical Austro-libertarian analysis is, unfortunately, as brain dead as it is dead right, in theory.\u00a0For a taste of it I refer you to the podcast I did recently with Peter Boockvar.\u00a0<\/a>But you\u2019ll hear similar analysis from Peter Schiff and his stable of writers.<\/p>\n

I don\u2019t disagree that the Fed is facing unpalatable choices. The Fed is trapped along certain vectors. It can\u2019t raise rates without causing a recession or destroying the yield curve.<\/p>\n

So, they argue, the Fed will have to reverse any rate hikes because if they don\u2019t it will blow up credit markets and then be blamed for killing the golden goose. Politically, it\u2019s always a non-starter. So, the Fed will raise rates and then give them all back.<\/p>\n

At what point will that happen? 1% on the Fed Funds? 1.5%? 3%?<\/p>\n

But there are a number of underlying assumptions in that conclusion that may no longer be accurate.<\/p>\n

And it is these assumptions that have led me to consider what if the Fed isn\u2019t operating based on the same metrics of the previous cycles?<\/p>\n

If you reject that outright, you get Mr. Boockvar\u2019s or Mr. Schiff\u2019s take. It\u2019s the safe conclusion. It\u2019s based on past behavior.<\/p>\n

But is it based on the current market conditions?<\/p>\n

I don\u2019t think so. In fact, I\u2019ve come to the conclusion that nothing about the current state of affairs politically, economically or militarily are anywhere close to similar to where we were in early 2019 when the Fed followed the ECB in cutting rates because their markets became unstable.<\/p>\n

I\u2019ve written extensively that I felt the Fed began tightening last June with their raising the payout rate on reverse repos to a measly 0.05%. This had the momentous effect of crashing the euro 3% in a day while Biden pushed confrontation with Russia over Ukraine out for another eight months in Geneva when he met with Putin.<\/p>\n

It ended any thought of a bull market in the euro versus the US dollar.<\/p>\n

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So, while I\u2019ve been arguing for a while that the Fed has been in tightening mode for months, the thing that eluded me was how were they going to pull that off without a repeat of past performances?<\/p>\n

The underlying assumption for this is that the Fed, as an advocate for U.S. commercial banking interests, is engineering a split with the Eurodollar system which has now reached the end of its \u2018use-by\u2019 date, given the dire fiscal circumstances the U.S. finds itself in.<\/p>\n

Moreover, I\u2019m further postulating, and I think with good reason, that the Biden Administration and most of the leaders in Congress do not work for American interests, but the opposite. It is the only realistic explanation for their behavior, especially since the beginning of Russia\u2019s war with Ukraine.<\/p>\n

So if Biden et.al. works for\u00a0Davos<\/em>\u00a0and\u00a0Davos\u00a0<\/em>wants an end to U.S. commercial banking dominance, then it makes sense they would need control over the Fed to pull off their move to central bank digital currencies (CBDCs) and create the apotheosis of the Great Reset.<\/p>\n

Under those conditions the Fed would absolutely act \u2018out of character,\u2019 leaning into the \u2018policy mistake\u2019 of raising rates into a stagflationary environment with US debt to GDP at 109%.<\/p>\n

Again, the problem arises, the minute the Fed goes hawkish they will have to reverse themselves quickly lest they torch the global credit markets.<\/p>\n

And this is where I think SOFR plays a big role in destroying the thesis that the Fed is trapped in the same way that it has been in times past.<\/p>\n

What is SOFR? The Secured Overnight Funding Rate. It is the U.S. domestic replacement for LIBOR. SOFR is market driven arrived at through actual transactions in the U.S. money markets with the daily quote arrived at by real data from real US banks.<\/p>\n

LIBOR, on the other hand, is a rate set by 17 foreign banks and 1 U.S. bank (JP Morgan Chase\u2019s London Division). It\u2019s still not market driven but arrived at by consensus. Regardless of that it represents the activity within London\u2019s and Europe\u2019s banking system, not the U.S.\u2019s.<\/p>\n

And therein lies the rub.<\/p>\n

For all intents and purposes for decades LIBOR was the mechanism by which City of London and Europe controlled the flow of dollars into and out of their banking system. No wonder the Fed had no real control.<\/p>\n

Broadly speaking, when the Fed raises rates and it causes a drain on the eurodollar system, it puts upward pressure on LIBOR. If Europe\u2019s banks are more exposed to a rise in the cost of dollars then LIBOR should blow out faster than the Fed raises rates.<\/p>\n

In past cycles, before SOFR, all US debt was indexed to LIBOR. So, it didn\u2019t matter if the Fed raised rates domestically, our mortgages, lease rates, and credit lines blew out with LIBOR even if there was no underlying stress in these domestic markets.<\/p>\n

Now, in 2022, with all US debt indexed to SOFR and almost all legacy debt reindexed to it over the past four years, when the Fed raises rates U.S. debt rates rise with it, rather than with LIBOR. In short, SOFR breaks the link where Europe or London\u2019s problems cross the pond and become our problems.<\/p>\n

It leaves them free to pursue insane monetary policy like, say, negative nominal rates, for a full decade but can no longer force the U.S., in effect, to fund it.<\/p>\n

As the Fed raises rates this summer the possibility exists that SOFR insulates the US from the havoc that the draining of eurodollar markets will have on LIBOR-indexed debt.<\/p>\n

Remember also that the SOFR crisis of 2019 was due to the U.S. markets running out of cash caused by U.S. banks refusing to take European debt as collateral for repos throughout the year. It forced the Fed to open up the repo window to provide that cash and alleviate the problem in the short term.<\/p>\n

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H\/T Chatham Financial<\/a><\/figcaption><\/figure>\n

This is a clear \u2018shot across the bow\u2019 from US commercial banks saying they were done financing Europe\u2019s debt orgy. The battle lines, I think, were drawn in 2019 and the next phase of the battle is on the table today now that Powell and company have a fully realized SOFR market operating in all areas of U.S. debt markets.<\/p>\n

This is what has changed. This is one more weapon in the Fed\u2019s arsenal to wrest control over U.S. policy, both fiscal and monetary, that it can use to assert its independence and put the U.S. back on something close to a sustainable path.<\/p>\n

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Europe, on the other hand, can no longer count on their controlling LIBOR to get the dollars they need from either a willing Congress and a trapped or captured Fed.<\/p>\n

Moreover, if you really begin to think through this, again in broad terms, it puts the new pricing system for commodities thanks to the Russians, i.e. rubles = gold = oil = commodities, on the other side of Europe saying in no uncertain terms\u00a0#GotGoldOrRubles?<\/a><\/p>\n

And they can\u2019t print the same number of eurodollars they used to. So, now what?<\/p>\n

This is where we are today. I laid out this whole thing in a recent interview with Chris Marcus at Arcadia Economics.<\/p>\n

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