Historically low interest rate volatility has taken its toll on fixed income revenues, forcing many dealers to streamline their business models and rethink the future of FICC as the driver of investment banking profits.
Those firms that have opted to hold steadfast to fixed-income centric models are pinning their hopes on the Fed’s tapering of asset purchases and expected 2015 rate hikes to revive flagging revenues by re-injecting volatility into the stagnant market.
But many predict they could be left disappointed as the Fed’s cautious approach to monetary tightening and increased automation of fixed income markets could conspire to keep volatility below historical norms.
“The number of machines trading with ruthless persistence in the wholesale market is getting greater every year and everything is pricing with greater precision,” said Mike Bagguley, head of macro products at Barclays. “Vol might pick up a little bit – enough that an efficient and focused bank will do well. We’ve now established a razor-sharp business that is well positioned to capture revenue in this new environment.”
The UK dealer recently merged its FICC and credit business across G-10 and emerging markets to create a more streamlined macro products group. Similar groups have also been created at Goldman Sachs and JP Morgan, while UBS has taken an agency approach to its fixed income operations (see “Rates businesses diverge”, IFR 2048 p49).
Auto shift
Regulatory changes implemented in the wake of the crisis require firms to clear standardised OTC swaps through central counterparties, while the most liquid interest rate derivatives must be traded over newly created swap execution facilities. Meanwhile, Europe’s MiFID II requirements will force more cash and derivatives products to trade on exchange-like platforms, bringing those markets closer in line with the highly automated foreign exchange world.
“FX vol seems to be very low right now but it’s amazing that currencies move around as much as they do given the level of electronification in that market,” said Bagguley.
When foreign exchange markets embarked on their rapid automation from the mid-1990s, a dramatic increase in transparency eliminated the dealer information advantage, creating smoother price moves, according to some traders. The shift has been instrumental in bringing retail investors into the market, now accounting for an estimated 3.5% of daily spot transactions or US$185bn of daily turnover, according to the BIS Triennial survey of 2013.
“FX price transparency is very efficient – so much so that even small retail players are able to access close to choice pricing,” said a fixed income trading head at one European firm. “There is still some volatility, but it is driven by fundamental factors rather than flow. In many other markets there are still information inefficiencies that drive volatility from the flow side.”
Some are yet to be convinced of any link between automation and volatility. An e-trading head at one US house points out that a large part of fixed income activity is already traded electronically, with over 90% of government and corporate bond business executed through automated platforms.
“What drives rates vol is policy, growth, inflation and longer term economic prospects. There’s no evidence to suggest that correlation between automation and volatility is real. There’s a received wisdom that it is there, but no one can provide a convincing argument why that should be,” said the trading head.
“There’s an equally valid argument in the other direction as with greater electronification, you get the possibility of flash-crash type volatility scenarios.”
Mixed history
Previous US rate hike scenarios offer little evidence that volatility will rise alongside the next tightening wave. For example, volatility remained subdued between 2004 and 2006 as rates ticked up from 1% to 5.25%.
“Even in the US we don’t expect volatility to challenge the highs, but we should see it return to mid-levels. If you measure volatility in percentage points, it may look historically high but if you measure it in basis points then it will look relatively calm,” said Charles Bristow, co-head of rates, EMEA, at JP Morgan.
“The recovery end of this cycle is unlikely to be as dramatic as in other cycles. Raising rates from zero is likely to be done in a more measured way than during prior periods of reducing rates.”
For most of this year, 10-year US dollar interest rate volatility has traded around 22% – in line with the pre-crisis lows of 2007 – and has seen little uptick even as conviction builds for mid-2015 to deliver the first US rate hikes in almost a decade. While most believe that current levels represent the lows, many think that volatility could languish at the bottom for some time to come.
Fixed income revenues may not yet be on the way up, but there is widespread belief that they have finally hit a trough. According to estimates from Morgan Stanley and Oliver Wyman, rates trading revenues more than halved from US$83bn at the 2009 peak to US$35bn in 2013. Revenues across the fixed income industry for the second quarter of this year showed a further 10% year-on-year decline.
“Industry revenues should now remain stable until there is a change in the volatility regime, and we’d hope that it will change in the middle of next year,” said Bagguley.
