Sonia, OIS, Risk Free Interest Rates

Libor elimination as written many times forced massive changes to markets as focus shifted from 2014 to 2016 to change market structures and prices through Overnight rates. The commonality to overnight adjustment was every nation on the planet was effected as all were forced to re structure.

Most important to Overnight revamp was the consistency nation to nation in term structures was complete and aligned. What aligned was interest rate maturities as well as normal OTC trade ability to Compound interest rates rather than average. Every nation now shares the same maturities from 30 days to 1 year.

Every nation now shares a uniqueness in their own markets as well as solid triggers and market signals to complete trades as levels, ramges and targets. To know any nation’s interest rates is to know any trading day’s Levels, Ranges and Targets in any financial instrument that trades. This includes any commodity to include Gold, Oil, Silver. This also includes Iron Ore in Australia, Dairy in New Zealand and other specialized commodities inherent to a specific nation. Now multiple trades are offered in any market. Currencies may trade for example against yields, stock markets, commodities.

The methodology to interest rate adjustment was to not only force activity in money market, interest rate trades but focus is short term as market designers are interested to ensure liquidity and profitability in banks, pension funds, major companies. Ease of trades and quick in and out to trades is the new order. Libor elimination allowed central banks and interest rate traders to become managers and control of markets rather than as under Libor to allow a market price to fly.

Libor elimination shortened term structures inside respective nations. GBP Libor Friday reported Overnight to 1 year from 0.4725 to 0.818 or a difference of 0.3462. Libor rates are not only wrong but far off the mark to consider a trade in any financial instrument.

Sonia reported 0.4668 to highs at 0.585 and 1 year at 0.775. From 585 to 0.4668 is a difference of 0.1192 and 0.3082 from 775. The new Sonia structure is far more realistic for trades yet trades aren’t going far because the ranges shortened. At 0.34 is a giant move in currency price land while 0.1192 and 0.30 is extremely short to ranges. Actual to Sonia is not 1 year or 6 month rates but 0.4668 to 0.5018 and 0.5137. Now we have 0.0350 and 0.0469. Libor massively dropped ranges from 0.34 to 0.0350 and 0.0469.

As Sonia reforms complete April 2018, the BOE markets committee is working to introduce a new Sonia Futures contract to allow a far better and more realistic term structure. Short Sterling contract appears to be heading for elimination in favor of Sonia / OIS against 1, 3 and 6 month contract durations. Sonia OIS will settle on a realized rate rather than a forward rate.
If Sonia OIS traded today, 1, 3 and 6 month factors to 0.0568, 0.0268 and 0.1182 at 6 months. GBP/USD then factors to 0.9907, 1.0197 and 1.0789. The purpose for the new term structure is to create lower and stable Borrow rates to lend higher in Repo Markets. Channels will compress, GBP exhange rates will suffer indirect effects by slower movements and interest rate trading will become far more robust particularly as Sonia / OIS will settle on realized rather than a forward rate. New daily curves and trend lines must be created everyday.

Sonia / OIS offers a new bottom for all UK financial instruments. More important, Sonia / OIS represents the next phase of markets by creation of Risk Free rates. The ECB is well underway in its Risk free interest rate creation and USD is complete with the New York Finance Rate, a rate however with little purpose or use as the Fed’s system of interest rates lacks a need for changes.

For market traders and written many times, spreads of prices and spreads between and among financial instruments is already seen. Far more of this type of trading will be seen in the future. Consider Sonia /OIS proposes spreads at 0.5. This represents a tiny price zone. Further, as Short Sterling Futures remain alongside GBP/OIS then Basis trading will become the new temporary order. As central banks compress ranges, more sophistication to trade will become the new order.

 

Brian Twomey

 

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