LIBOR shift succeeding as Sonia hedging surges on volatile rates
Bloomberg Market Specialist Luca Bianchi contributed to this article. The original version appeared first on the Bloomberg Terminal.
Background
The sterling interest-rate derivatives market has been bustling as investors seek to hedge against the possibility of central bank surprises. This comes amid a lengthy and complex transition away from LIBOR to a risk-free benchmark.
With LIBOR, a rate that has for decades been a key component of the global financial system, sunsetting at the end of 2021, interbank offered rates (IBORs) like LIBOR are being replaced by a new generation of risk-free rates (RFRs) in an ongoing financial reform movement taking place worldwide. The Sterling Overnight Index Average (Sonia), administered by the Bank of England, has ramped up as the new benchmark rate for the British pound, and the Secured Overnight Financing Rate (SOFR) has become a key rate for the U.S. dollar. Central banks across Europe and Asia have also launched RFRs.
The issue
In March, The Bank of England (BOE) raised its key interest rate to 0.75%, bringing borrowing costs back to a pre-Covid level. With the hike coming for the third successive policy meeting, officials warned inflation could top 8% later in the year. War in Ukraine leaves uncertainty around the outcome of a global economic recovery following two years of pandemic. With fears of increased inflation and slowing growth, many are looking to see how central banks will respond.
A Bloomberg analysis of Sonia futures showed the market priced in February had the highest implied volatility for low-delta options that would mature in March, as well as for other near-term contracts, offering protection against rate moves that could come in the first half of 2022. These extreme bets on three-month rate expectations will certainly be affected by BOE policy signals. With positioning re-adjusting and market expectations stabilizing, the shape of the surface normalized, with higher volatility priced on longer maturity contracts.
“With the tone from central banks turning hawkish in the face of persistently high inflation, we’ve seen large swings in the white futures (the first 12 months of expiries), with the June contract dipping through 98.30 before heading back above 98.60,” said Thomas Bamford-Murphy, an institutional trader at Maven Securities in London. “Initially, during this volatile period, we saw the focus largely remain on the upside in the whites with the large proportion of trading targeting May and June rates in the 1-1.25% region. With the recent increase in uncertainty, there’s less of a clear focus.”
A look at volumes and open interest for three-month futures indicated a surge, as prices plunged on expectations of BOE rate hikes as well as open LIBOR contracts transitioning into Sonia. An increase was also seen last September, with price gyrations breaking nine months of stability in Sonia futures. Despite Sonia being a fundamentally different reference rate than LIBOR, as it leaves credit spread out of the calculation, the increase in activity so far seems promising and indicative of a transition to RFRs that has so far gone smoothly.
“The removal of the FRA-OIS spread – the difference between the three-month LIBOR and the three-month overnight swap rate – minimizes the impact of credit risk and liquidity premium,” said Bamford-Murphy. “Overall, the market has then transitioned without fanfare, despite there being concern that the removal of the credit spread would suffocate some of the activity.”
Tracking Sonia volatility
Bloomberg functions revealed March and other near-term contracts had the highest implied volatility.
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