In the labyrinth of financial markets, where each decision can tilt the scales of fortune, certain benchmarks stand as the guiding stars. Names like the Federal Funds Rate (FFR), Effective Federal Funds Rate (EFFR), Secured Overnight Financing Rate (SOFR), and the 10-Year US Treasury Yield (10Y UST Yield) often swirl around conversations among investors. But what exactly are these benchmarks? How do they differ, and more importantly, how can they inform our investment strategies, especially with the Federal Reserve eyeing a potential 25 basis points (bps) rate cut in September 2024? Let’s dive into these critical rates, their interconnections, and how they could shape the landscape of your portfolio.

Summary

• ‍Decoding Benchmark Rates: Key rates like FFR, EFFR, SOFR, and the 10Y UST Yield act as the financial market’s navigational stars, each serving distinct roles in the market.‍
• Rate Ripples: With a potential Fed rate cut in September 2024, these benchmarks will shift, impacting everything from short-term lending rates (EFFR & SOFR) to long-term yields (10Y UST Yield).‍
• SOFR’s New Role: SOFR is increasingly being used in structured products such as the Autocallable Phoenix Note, offering potential opportunities in a rate-cutting environment.‍
• Goodbye LIBOR, Hello SOFR: As LIBOR fades, SOFR steps in as the new gold standard, offering more transparency and reliability in financial markets.‍
• Investor Takeaway: With key events on the horizon, investors should keep a close watch on these benchmarks to make smart, timely decisions that could protect and grow their portfolios.

1. Understanding the Benchmarks: FFR, EFFR, SOFR, and 10Y UST Yield

Federal Funds Rate (FFR): The Fed’s Target

The Federal Funds Rate is perhaps the most well-known of the bunch. It’s the target interest rate range set by the Federal Reserve for overnight lending between banks. Think of it as the Fed’s way of signaling its monetary policy intentions. However, it’s crucial to note that the FFR is a target rate—more of a suggestion than the actual rate at which transactions occur. To guide the FFR toward its target, the Fed uses Open Market Operations (OMO), buying or selling the US Treasury securities to adjust the amount of money banks have on hand, subtly nudging the rate in the desired direction. For example, when the Fed buys UST, it injects liquidity into the money market, thus lowering the FFR. Conversely, when the Fed sells UST, it withdraws liquidity from the market, thereby raising the FFR.

Effective Federal Funds Rate (EFFR): The Market’s Reality

On the other hand, the Effective Federal Funds Rate (EFFR) is where the rubber meets the road. It’s the actual weighted average interest rate at which banks lend reserve balances to each other overnight. Unlike the FFR, which is set by the Fed, the EFFR is driven by market transactions. It fluctuates within the Fed’s target range (currently 5.25-5.5%) and is calculated daily by the Federal Reserve Bank of New York. On the day of writing, the current EFFR is 5.33%.

Secured Overnight Financing Rate (SOFR): The Collateralized King

SOFR is a newer player in the game, but it’s quickly becoming a heavyweight. Unlike the FFR and EFFR, SOFR is based on transactions in the overnight repurchase agreement (repo) market. In a repo transaction, one party sells US Treasury securities to another with an agreement to repurchase them the next day at a slightly higher price. This rate is secured by collateral—high-quality US Treasuries—which makes it less risky than the unsecured FFR and EFFR. SOFR is usually lower than EFFR due to its collateralized feature. On the day of writing, the current SOFR is 5.32%.

10-Year US Treasury Yield (10Y UST Yield): The Long-Term Sentinel

While the FFR, EFFR, and SOFR are overnight rates dealing with the short-term, the 10Y UST Yield offers a glimpse into the future. It’s the interest rate the US government pays to borrow money for ten years, making it a key indicator of long-term interest rate expectations. Investors flock to the 10Y UST Yield for its stability and as a benchmark for pricing - from mortgages to corporate bonds.

2. The Interconnected Web: EFFR, SOFR, 10Y UST Yield, and 2Y UST Yield

With the July CPI easing back towards the Fed’s 2% target, retail sales outperforming consensus forecasts, and weekly jobless claims data supporting a soft landing, the anticipated 25 bps rate cut by the Fed in September 2024 is likely to ripple through these benchmarks, affecting everything from short-term lending rates to long-term yields.

EFFR and SOFR: The Short-Term Duo

The EFFR and SOFR, both operating in the short-term market, often move in tandem. A rate cut by the Fed typically pushes the EFFR lower, as banks adjust their overnight lending rates within the new target range. SOFR, being based on secured transactions, also tends to follow suit, though its movements can be more stable due to the collateralized nature of repo transactions.

SOFR 10Y Swap Rate and 10Y UST Yield: Swap Spread Considerations

In structured products, SOFR Swap with a specific term (known as SOFR Constant Maturity Swap (CMS) e.g. SOFR 10Y Swap depending on the structure of product) is used instead of SOFR (an overnight floating rate) to provide a fixed long-term benchmark interest rate for coupon payment. In a SOFR 10Y Swap, one party agrees to pay a fixed interest rate (known as the SOFR 10Y Swap Rate) determined when entering the swap agreement and being constant over the life of the swap (Fixed Leg), while the other party pays a floating rate based on the SOFR, which is an overnight floating rate that resets periodically (Floating Leg).

SOFR 10Y Swap Rate and 10Y UST Yield are two typical benchmark rates used in structured products. The spread between the SOFR 10Y Swap Rate and the 10Y UST Yield, known as the swap spread, is a critical indicator of credit risk in the financial sector. It reflects the difference in credit risk between the US government (considered risk-free) and the financial institutions involved in the swap. A positive swap spread indicates that the fixed rate on the swap is higher than the UST yield, suggesting higher perceived credit risk in the financial sector compared to the US government. Conversely, a negative swap spread would indicate the opposite. By the time of writing, the swap spread is -0.431% (3.435% - 3.866%), implying that the US government is perceived riskier than the financial sector, which is abnormal and an inversion of the typical risk hierarchy between swaps and UST. In this case, investors are driven by “flight to safety” in private sector instruments, eying on quality assets like the high grade/investment grade corporate bonds or even swaps, as safer than the UST. This would further drive down their yields and widen the negative swap spread. This could manifest as increased volatility, liquidity shortages, and a lack of confidence in the financial markets.

10Y UST Yield and the 2Y UST Yield: The Long and Short of It

The 10Y UST Yield and the 2Y UST Yield are closely watched indicators of market sentiment and Fed policy expectations. A Fed rate cut is likely to push the 2Y UST Yield lower, reflecting expectations of lower short-term rates. The 10Y UST Yield, however, could either fall or rise depending on how investors interpret the Fed’s move—whether as a sign of economic weakness (leading to lower yields) or as a relief rally (pushing yields higher).

Understanding these interconnections can help investors navigate potential market moves and adjust your asset allocation accordingly, whether that means locking in the current high 10Y UST Yield for capital appreciation or positioning yourself to benefit from a lowering SOFR with structured products.

3. SOFR CMS and Structured Products: A New Frontier

SOFR isn’t just a benchmark; it’s also the backbone of various structured products. One such product is the Autocallable Phoenix Note, which uses the SOFR 10Y CMS Rate as its underlying asset.

The current USD SOFR 10Y CMS Rate is 3.435%. In the past 15 years, there were only 78 days where the USD SOFR 10Y CMS Rate is higher than 4.0%. Now with the anticipated Fed rate cut in September, investors will profit from the high annualized phoenix coupon of 7.53% as the USD SOFR 10Y CMS Rate is lowered. This product is designed to take advantage of entering interest rate cut channel, offering attractive returns while maintaining principal protection. The quarterly observation and payment structure provide regular income, making it a compelling option for income-focused investors.

4. SOFR vs. LIBOR: A New Era of Benchmarking

LIBOR (London Interbank Offered Rate), once the gold standard of interest rate benchmarks, now is phased out in favor of SOFR. Introduced in 2017 and fully replacing LIBOR in 2023, SOFR becomes the financial market’s preferred benchmark for structured products and loans as it is grounded in real transactions in the US Treasury repo market, making it more reliable and transparent, while LIBOR was based on estimates rather than actual transactions, which made it vulnerable to manipulation.

5. Navigating the Rate Maze in a Dynamic Macro Environment

As we approach key events like Jerome Powell’s upcoming speech at Jackson Hole on 8/23, the September 17/18 FOMC meeting, and the latest macroeconomic data releases, investors should be attuned to the movements of these benchmark rates. Whether you’re locking in the current high 10Y UST Yield for capital appreciation or positioning yourself to profit from potential SOFR-based structured products, understanding these benchmarks and their interconnections is crucial. By keeping a close eye on these benchmark rates and anticipating how they might react to upcoming macro events, investors can make informed decisions that not only protect your portfolio but also capitalize on emerging opportunities.

Stay vigilant, stay informed, and let the benchmarks guide your way.