U.S. INTEREST RATE DISLOCATION INTENSIFIES / THE FINANCIAL TIMES

US interest rate dislocation intensifies

Joe Rennison




Banks and investors say an intensifying dislocation between two important sectors of the US interest rate market reflects the new era of tougher bank regulation that has significantly increased capital costs.

The pressure on banks’ balance sheets shows little sign of easing ahead of the financial year ending, a period often characterised by a rush among the trading community out of assets such as bonds and derivative contracts and into cash.

“At the end of the third quarter we saw real stress on balance sheet availability and cost. At the end of the fourth quarter it will be at least as bad,” said Michael Cloherty, head of US rates strategy at Royal Bank of Canada.

Historically, large US banks acting as middlemen across fixed income and interest rate derivative markets could warehouse positions on behalf of their clients such as hedge funds, asset managers and companies. In recent months, US interest rate market activity that links Treasury bonds and derivatives has become severely impaired, due to higher capital costs and a tough trading environment, marked by a number of funds closing.

A barometer of the current market stress is the fact that swap rates are being quoted further below Treasury bond yields, a negative relationship that upends financial theory and under normal market conditions should be swiftly reversed.

The current 10-year swap rate of 2.11 per cent sits nearly 10 basis points below the 10-year Treasury note yield of 2.21 per cent, a record inversion. Traders say the move is significant because it shows the increased cost of holding assets on balance sheet is preventing dealers facilitating a reversal of the trend.

Interest rate swaps are used widely by companies and institutional investors to facilitate the exchange of floating rates of interest for fixed rates. The fixed rate, like that of bonds sold by companies, has historically been above US Treasury yields. A positive spread between swaps and Treasury yields reflects the greater risk of transacting a privately negotiated derivative contract compared with a bond backed by the US government.

“Swap spreads are very concerning and one of the primary symptoms of the broken market,” said Jason Prest, trader at III Capital Management.

Typically, the dislocation would be reversed by hedge funds eyeing an arbitrage opportunity from buying US Treasuries and paying the fixed rate on a swap.

 

Such positioning makes money as swap rates rise over Treasury yields. 

But many hedge funds do not have the cash to buy the debt outright, so borrow it from banks through repurchase agreements, or “repo”. In turn banks source the cash to lend to hedge funds from mutual funds. But the problem facing banks is that such cash flowing between different investors via repo trades sits on their balance sheets, consuming capital.

“Trying to put on a position now in order to pay spreads is a difficult proposition because it is so capital intensive,” says a swaps trader at a European bank.

Contributing to the inversion between swap rates and Treasury yields has been the selling of US Treasuries by foreign central banks. A desire to prop up currencies against a strong dollar among emerging market economies is forcing a continuation of that trend, coupled with other investors selling Treasuries ahead of a possible Federal Reserve interest rate rise in December.

Also placing downward pressure on swap rates in relation to Treasury yields has been a number of companies selling bonds and swapping the fixed coupons for a floating rate exposure.