Interest rate derivatives: The rates business rated for 2008
Libor
Over the past 12 months, central banks have become adept at providing liquidity to the markets when and where it is required. As a result, systemic risk is reduced relative to mid-2007, although a few under-capitalized banks have failed.
However inter-bank Libor and Euribor rates have remained stubbornly wide to central bank rates, despite aggressive action by the Federal Reserve, European Central Bank and Bank of England. This has undermined the monetary policy transmission mechanism and challenged clients’ trust in the stability of the Libor-based markets – around which the fixed-income derivatives industry is based.
Although the banks are developing new OTC markets – notably overnight index swaps (OIS) – to provide an alternative to Libor, the risk is that unwelcome additional uncertainty in Libor will drive clients away from derivatives and towards cash markets and exchange-traded products.
The great Libor debate continues through 2008, with spreads to OIS as wide as ever. JPMorgan and Deutsche Bank – the leaders in US dollar and euro swaps respectively – have divergent views of the future for OIS, one possible replacement.
"We are seeing increased activity in long-dated OIS-based swaps and expect that part of the market will gravitate towards this as an alternative benchmark to Libor," says Felson.
Given the "massive legacy portfolios of swaps tied to three-month/six-month Libor," Felson expects "liquidity to remain deep in this market". But, he adds: "We are seeing increased activity in long-dated OIS-based swaps and expect that part of the market will gravitate towards this as an alternative benchmark to Libor."
JPMorgan’s Willcox is not so sure. "Libor is not as broken as many believe," he says. "A recently developed alternative index [Icap’s Libor replacement – the NYFR] appears to track Libor levels pretty closely. And there are so many existing contracts linked to Libor that it is not going anywhere in a hurry." But the medium to long end of the OIS market "will not gain significant momentum in the short term" in the bank’s view.
Hedge funds
While outperforming plunging equity indices, hedge fund returns have been modest, at best, in 2008, and there have been well-publicized collapses of hedge funds in the structured credit sector. In March, forced deleveraging by hedge funds facing losses in the credit markets spread to the rates markets. The contagion hit rapidly and unpredictably – creating pockets of chaos, wiping out profits at bank prop desks and wreaking havoc at fixed-income relative value hedge funds.
A prominent example is the Endeavour relative value fund. Despite widely respected portfolio managers and a record of stable returns in the long term, Endeavour suddenly suffered major losses as a result of unprecedented moves in JGB asset swap and cross-currency basis swap positions. The fund is said to have lost $800 million, about 25% of its value, in a single day and is down almost 40% year-to-date.
The relatively poor returns across the hedge fund industry at large, and negative publicity as a result of fund failures, have increased the propensity for investor withdrawals. That, combined with a general reduction in risk appetite and a wish to reduce leverage in difficult conditions, mean hedge funds are no longer providing the same level of liquidity to dealers. At the same time, reduced risk appetite at the banks themselves has magnified the effect. These factors also have an adverse effect on the revenue streams of the rates business.
The curve steepener turns tail
By March of this year the Fed had reduced systemic risk by extending its lending to the inter-bank market via a range of new mechanisms, including the Treasury Auction Facility. The US authorities then underlined the implicit too-big-to-fail maxim when the Fed orchestrated the bailout of Bear Stearns. Suddenly the flight-to-quality trade – which had supported the short end of the curve and a major steepening trend – was no longer the key driver. The market panicked as inflation data worsened and Fed rhetoric turned hawkish.
During the three months from mid-March to mid-June, two-year treasury yields more than doubled from 1.35% to 2.90%.
The curve flattened aggressively, with the two-year/10-year swap curve plummeting from above 180 basis points to less than 100bp. Stop losses hastened the move. The Fed might have delivered the banking sector from Armageddon but a flatter curve makes for a more difficult environment for banks in general – and it punched a hole in the short-end rally and structural steepening position that had supported rates division profits since the onset of the credit crisis in 2007.
Exotics
The curve-flattening trend was initially driven by events in the US, although these also had a major impact on the euro curve. By the beginning of June, the two-year/10-year euro swaps curve had inverted to almost –20bp. Curve inversion is always a sign of strain in the markets. In particular, exotics rates trading desks at the major banks held positions related to hedging of structured notes, negative gamma positions where losses multiplied rapidly in the event the curve faces a major inversion.
The exotics desks were already jittery and primed for the risk of further inversion when ECB president Jean-Claude Trichet shocked the markets on June 5 with the promise of an unexpected rate increase in July, and left open the possibility of more tightening to follow. With that announcement, the curve inversion assumed unprecedented proportions – inverting over 50bp in three days to reach a low of –70bp. The speed and magnitude of the move reflected panic trade from exotic rates desks forced to unwind their risk. The consequent losses at the exotics desks – which reportedly reached into the hundreds of millions of euros at certain banks – added to the flattening-related losses elsewhere in the rates business. The curve has since disinverted somewhat but still remains in the red, and vulnerable to a repeat of June’s chaos.