Over the past several months, one of the biggest conundrums stumping the financial community has been the record negative swap spread which
we profiled first in September, and which as Goldman
most recently concluded, "has been driven by funding and balance sheet strains, especially since August."
Today, in its
latest quarterly report, the Bank of International Settlement focused precisely on this latest market dislocation. According to the central banks' central bank, "recent quarters have witnessed unusual price relationships in fixed income markets. US dollar swap spreads (ie the difference between the rate on the fixed leg of a swap and the corresponding Treasury yield) have turned negative, moving in the opposite direction from euro swap spreads (Graph A, left-hand panel)."
Given that counterparties in derivatives markets, typically banks, are less creditworthy than the government, swap rates are normally higher than Treasury yields because of the additional risk premium. Hence, the negative spreads point to a possible dislocation. One set of factors relates to supply and demand conditions in interest rate swap and Treasury bond markets. In the swap markets, forces that can compress swap rates include credit enhancements in swaps, hedging demand from corporate bond issuers, and investors seeking to lock in longer durations (eg insurers and pension funds) by securing fixed rates via swaps.
In cash markets, in turn, upward pressures on yields stemmed from the recent sales of US Treasury securities by EME reserve managers. The market impact of these Treasury bond sales may have been amplified by a second set of factors that curb arbitrage and impede smooth market functioning. First, the capacity of dealers’ balance sheets to absorb rising inventory may have been overwhelmed by the amount of US Treasury bonds reaching the secondary market in the third quarter (Graph A, centre panel), causing dealers to bid market yields above the corresponding swap rates. Second, balance sheet constraints may have made it more costly for intermediaries to engage in the speculative arbitrage needed to restore a positive swap spread. Such arbitrage is sensitive to balance sheet costs because it requires leverage, with a long Treasury position funded in the repo market.
Meanwhile, while US swap spreads hit record negative levels, in Europe the market tensions have been of a different nature:
Ten-year swap spreads started to widen in early 2015, around the time when the Swiss National Bank abandoned its currency peg, then increased further over subsequent months (Graph A, left-hand panel). While past episodes of widening swap spreads can be attributed to credit risk in the banking sector, the most recent developments may have more to do with hedging by institutional investors. While swap rates also fell (Graph A, right-hand panel), the swap spread widened, indicating that cash market yields fell by even more. One possible explanation is that, as yields fall amid expectations of ECB asset purchases, institutional investors with long-duration liabilities, such as insurers and pension funds, would have been under pressure to extend their asset portfolio duration by purchasing additional longer-dated bonds, possibly compressing market yields below the swap rates.
And with cash markets rapidly depleting of physical inventory as a result of central bank monetization, investors have had to rely on derivatives markets, especially swaptions.
In addition to extending portfolio duration by purchasing longer-dated bonds or entering a long-term interest rate swap as a fixed rate receiver, investors may also hedge the risk of steeply falling yields by purchasing options to enter a swap contract at a future date (swaptions). Hence, swaptions tend to become more expensive in times of stress and when investors rush to hedge duration risk.
As 10-year swap rates were compressed in early 2015, the cost of such options written on euro swap rates rose by a factor of three by 20 April 2015 (Graph B, left-hand panel). Steeply rising euro rate hedging costs preceded the actual correction in yields, which started rebounding around the weekend of 18 April culminating in the so-called bund tantrum. This suggests that this year’s turbulence in fixed income markets may have had its origins in derivatives and hedging activity, with reduced market depth in cash markets exacerbating the spillover.
Why is there reduced market depth in cash markets? Simple: because of central banks intervention and soaking up of securities. So what the BIS is effectively saying is that as a result of central bank activity, investors have been forced to transact increasingly in the derivative arena as a result of which events like the Bund flash smash from April led to major market losses for those long Bund duration in either cash or derivative markets. Since then, volatility in European government bond markets has persisted culminating with the surge in yields this past Thursday in the aftermath of the ECB's dramatic and extensively discussed here previously "disappointment."
The BIS' conclusion:
Such volatile movements in euro area interest rate derivatives markets raise questions about smooth pricing responses in the face of possibly transient order imbalances. Of question is liquidity in hedging markets and the capacity of traditional options writers, such as banks, to provide adequate counterparty services to institutional hedgers. Looking back at the events of late April, the rise in demand to receive fixed rate payments via swaps by institutional hedgers may have run into a lack of counterparties willing to receive floating (pay fixed) rates amid sharply falling market yields. The emergence of one-sided hedging demand pressures can be gleaned from the skew in swaption pricing (Graph B, centre and right-hand panels). The skew observed for euro rates approaching the bund tantrumresembled the developments in US dollar rates in December 2008, when US pension funds rushed to hedge interest rate risk via swaptions as market yields tumbled.
But while the swap dislocation in the bond market can be attributed to anything from market illiquidity, to a shortage of cash market product, to lack of willing counterparties, to HFTs, and ultimately, to encroaching central bank intervention - something we have been warnings about since 2012 - perhaps an even more important question to emerge when observing broken swap markets are recent development in FX basis swaps.
This is how JPM explained most recently the phenomenon which can simply be ascribed to a global dollar funding shortage:
"continued monetary policy divergence between the US and the rest of the world as well as retrenchment of EM corporates from dollar funding markets are sustaining an imbalance in funding markets making it likely that the current episode of dollar funding shortage will persist."
The BIS also touched on this topic in its quarterly review, when it picked up the "policy divergence" torch from JPM and describing the ongoing USD funding shortage as follows:
The increased likelihood of policy divergence between the US, the euro area and other major currency areas also rippled through global US dollar funding markets.Historically, cross-currency basis swap spreads – a measure of tensions in global funding markets – were virtually zero, consistent with the absence of arbitrage opportunities. Since 2008, the basis has widened repeatedly in favour of the US dollar lender, ie there is a higher cost for borrowing in dollars than in other currencies even after hedging the corresponding foreign exchange risk – conventionally recorded on a negative basis (Graph 5, left-hand panel). As such, negative basis swap spreads indicate the absence of arbitrageurs to meet heightened demand for US dollar liquidity.
Visually:
To be sure, our readers were aware of this implication of diverging monetary policy. However, thanks to the BIS, we now can add a quantitative dimension to what until recently what mostly a qualitative problem: i.e., how much is the dollar shortage as implied by the near record negative USDJPY currency basis swap spreads.
The US dollar premium in FX swap markets widened substantially – in particular vis-à-vis the Japanese yen – after the odds of Fed tightening reached 70%. At the end of November, the basis swap spread of the Japanese yen versus the US dollar was minus 90 basis points, possibly reflecting in part the more than $300 billion US dollar funding gap at Japanese banks.
The BIS does its best not to sound the alarm at this stunning observation:
While funding continued to be available, such a large negative basis indicates potential market dislocations. And this may call into question how smoothly US dollar funding conditions will adjust in the event of an increase in US onshore interest rates. Similar pricing anomalies have also emerged in interest rate swap markets recently, raising related concerns.
Indeed, once the Fed does hike rates as it now seems almost certain it will do in 10 days time, we will find out just how profound the USD funding shortage truly is. Readers may recall that in
2009 we cited a BIS report which said that "were all liabilities to non-banks treated as short-term funding,
the upper-bound estimate [of the dollar short] would be $6.5 trillion".
This time around, as a result of the dramatic increase in USD-funded debt around the globe in the past 5 years, it will certainly be far greater.
And, as a further reminder, the last time a global USD margin call was launched with the failure of Lehman, the Fed had to unleash an unprecedented global bailout by way of virtually limitless swap lines opened with every central bank that has a shortfall in USD exposure.
As a result, our only question for the upcoming Fed rate hike is how long it will take before the Fed, shortly after increasing rates by a modest 25 bps to "prove" to itself if not so much anyone else that the US economy is fine, will be forced to mainline trillions of dollars around the globe via swap lines for the second time in a row as the world experiences the biggest USD margin call in history.
