Alan Greenspan has been agonising in public through his last year as Federal Reserve chairman about the conundrum of stubbornly low long-end interest rates in the face of central bank short-dated hiking. Mark Pelham looks at how swap dealers and their clients are coping with flat interest-rate curves.
The conundrum on which the Fed chairman has been musing over the past year – falling long yields – is not only an issue for US dollar swap dealers; it has been a global one. There were some signs of a long-awaited steepening of the curve in the sterling market in early October, but the flattening trend looks set to continue elsewhere.
In the euro market the forward path of 30-year rates for the next seven years, as reflected by the forward swap market, is more or less the same as current levels, according to Meyrick Chapman head of derivatives strategy at UBS.
“Furthermore,” he added, “current market conditions, taking into account current swaption volatilities, predict there is a reasonable chance that euro 30-year rates fall below 3% within 4 years – currently there is a 17% chance of that occurring – whereas in September 2004 the probability of 30-year rates falling below 3% within four years was 0.4%, i.e. vanishingly small.” (See chart)
“A flat curve makes everybody’s life more challenging,” said Jon Kinol, head of rates for the Americas at Deutsche Bank. “One of the easiest ways to make money in the swap market is through positive carry and traders have made large
sums of money over the last few years just by being long the front end. Coupled with that, banks were able to hold significant amounts of mortgages financed at relatively low rates in the deposit market and lock in relatively large margins. The flatness of the curve, especially at the front end, has put a dent in those strategies and made it much more difficult to generate this type of revenue.”
Jan Loeys, global market strategist at JPMorgan, observed that markets are being held in very tight ranges, which reduces trading opportunities for market participants. “The global economy is pretty much growing at a straight line with the stimulative impact of low yields being offset by the negative impact of high oil prices. The result is depressed volatility, which in turn reduces the compensation for risk at the shorter end of the swap curve,” he said.
Normally, traders expect short-end swaps to provide a premium in excess of consensus projections for central bank interest rate movements to compensate for the lack of certainty over those projections. Historically one-year three-month Libor forwards offered a premium of around 25bp and two-year onwards about 50bp. But currently both forwards are flat to projections if not below what most observers and economists expect central banks in major economies are going to do.
As a result, Loeys said: “Not only do you currently get little carry, any anticipation of hanging on to one- or two-year receivers for the risk premium has been eliminated, meaning you are just going to break even. So, it makes it very hard for banks to purely make money on swaps from typical carry-and-slide strategies. To combat this they have tried to earn returns from more active trading. Some have been decent at it, some have not – there is quite a bifurcation among the banks in terms of trading results this year.”
Asset managers are having an equally hard time according to Loeys. “Those with fixed income portfolios have been more on the short duration side because yields are much lower than is typical in a tightening cycle. But they have stayed that way and so they have underperformed their index and they are continuing to be blown apart by the flows coming into the interest rate markets, which are emanating from a reallocation of global savings towards investors who have a strong preference for fixed income – central banks, commercial banks receiving cash inflows from corporates – that depresses the return you get from going out along the curve.”
Market participants have been looking to take on alternative risks to compensate for the flat curve. Kinol said: “Most notable has been a move to short gamma. In normal circumstances with a steep curve, banks might be concerned about a rates back up or other potentially hurtful scenarios, but there is enough margin left over that they can hedge out the wings on some of those risks. What has happened recently is that both banks and hedge funds have been looking to augment returns - banks are long mortgages and buying fewer options, hedge funds are selling more options to pick up yield.”
Structured product investors have also been affected by the current curve shape – a steep curve with high volatility makes for attractive coupons but a flat curve with low volatility means the yields are less attractive. Consequently they have had to move to different structures to maintain yield.
Investors are looking at various forms of structured products that one way or another exploit higher implied volatilities further out along the curve, according to Loeys. “Banks are effectively creating a cocktail of longer maturity options that earn income from writing longer term volatility structures. There has been a strong business in that, which is normal in a low volatility environment – the lower the volatility in the market the more investors are willing to go out along the risk-return trade-off line.”
One play that is proving popular at present revolves around the potential for the curve to go beyond flat. Kinol said: “Clients look at the current shape of the curve and know that historically it has very rarely inverted and are willing to bet that the curve will not go flat. Even though the curve is inverted on a forward basis, clients are betting that the curve will not stay flat for an extended period of time and are buying structures that take that view.”
In Europe, this has manifested itself in the form of large volumes of constant maturity swap (CMS) structures. UBS figures show that 94% of global CMS structures with an issue size greater than US$50m equivalent from the beginning of 2004 to September 2005 have been denominated in euros. This included all 23 deals that were greater than US$250m.
“European CMS demand is driven by a belief that the prolonged yield curve flattening will not end in a prolonged yield-curve inversion. History suggests European investors have good reason to bet against inversion. The spot 10-year 30-year structure – which many CMS trades reference as an index – has never inverted, achieving a low point of 13bp in May 2000.
There is an element of self-fulfilling prophecy with such deals, as part of the dealer hedge for CMS issues includes an offsetting steepening position in the swap market. “The large amount of CMS is probably one reason why the 10-year against 30 year curve structure has lagged the flattening seen in shorter maturities,” Chapman said.
Nevertheless the expectation remains that flattening pressure will increasingly outstrip steepening CMS-related flows. The belief primarily revolves around ever increasing long-dated demand – while long-dated bond issuance has increased over the past year it has also consequently generated increased demand from duration index benchmarked buyers and, at the same time, there is increasing regulatory pressure on pension and insurance funds to hedge asset-liability mismatches.
Dutch funds had been expected to be the first movers in this regard this year, but in September their regulator postponed its proposed new asset-liability management (ALM) framework until 2007. The move was believed in part to be a result of concerns raised by the funds over having to hedge in such a low yield environment.
Notwithstanding yield level concerns, dealers expect activity to increase from funds in other jurisdictions. While German insurers potentially have the largest ALM issues there are, as yet, few signs of any activity from them, whereas Swedish and Swiss funds are understood to have initiated trading in advance of their new ALM frameworks being implemented.
Such activity is expected to primarily take place in the euro market, as there are insufficient local currency-denominated long-dated assets in either Sweden or Switzerland to meet demand. Equally it is expected that funds from both countries will utilise interest rate derivatives as they have the advantage over bonds in terms of up-front capital costs.
As a result, and despite the cost of carry, many are now considering putting on or adding to swap flattening positions. As Chapman said: “ALM managers around Europe are increasingly encouraged to hedge the risk of catastrophic low rates. The higher the probability that they will face those catastrophic low rates, the higher the probability they will have to hedge, both to satisfy regulators and to pre-empt their competitors. With such a background, this does not look a particularly propitious time to bet on future steepening of the euro yield curve.”