Tag Archives: swaps

The Real Action Is In The Funding Curves

Real quickly, I want to revisit this post from last week because I compiled some Euribor curves, looking for signs of stress in European banks.  I noted there was no sign of any fear:

Here are updates of EONIA swaps and Euribor:

EONIA has started to flatten out, particularly dramatic in the long end of the curve.  But the front-end remains anchored.

Euribor? Comatose.

And then it hit me…

They don’t matter.

Here’s what matters: the spread between dollar Libor and Euro Libor.  I compiled monthly snapshots of the curve going back to the beginning of the year (I love my readers but I’m not compiling 150+ daily Libor curves by hand):

You see it compressing rather dramatically.  The reason is dollar Libor has been catching up to Euro Libor.  The mad dash for dollars on the European continent is on.  So viewed from that perspective, the Euro curves can be shaped any way they want at whatever levels – nobody is using Euros to fund themselves.

And I also noted the TED spread.  It’s widening again. The chart is from yesterday, but today’s quote is at 31bps – another 6bp increase:

What makes the spread so disconcerting is this: the last time we saw a gigantic blow-out in the TED spread was before this:

TED blew out before some of these data sets existed.  These are all Federal Reserve programs to bolster liquidity in the banking system.  They’ve pulled out all the stops, and Fed funds trade around a range instead of a target.  Everything that could be done has been done to dampen volatility in short-term funding.  And it worked.

Until now…

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One Model, the Search for Irving Fisher and A Hell Of A Lot Of Implications

This is going to cover a lot of ground, hopefully well.  But it’s simply too juicy to pass up discussing.  One of my friends on Twitter turned me on to this post at FT Alphaville.  The first thing you notice is the chart:

It’s kind of busy, but what it is tracking through time are EURUSD, the 2yr EURUSD swap spread and a sovereign CDS spread of unhealthy European countries vs. Germany.  For once the CDS data is not the data series to focus on.  For this post, we’re going to focus on the swap spread and exchange rate.

The FT Alphaville post explains the basic premise underlying the trade:

Funds trading the Euro-US dollar (EURUSD) typically use a pair trading technique pinched from equities trading models. The currencies model buys EURUSD on a statistical dip below the level of EURUSD implied by the 2-year swap spread. In other words, it assumes a mean reversion between the swap spread and the currency pair.

This is a slightly nuanced take on an effect defined by Irving Fisher many many moons ago called the International Fisher effect.  The essence of the effect can be found in this equation:

What it says is that you can estimate the percent change in a currency’s exchange rate based on the interest rate differential between the two countries.  I’m including a document that gives you some more details about how exactly this works and its complete with spreadsheets:

So what does this have to do with the EURUSD trade?  Simple: first, you calculate an implied exchange rate  by plugging in the respective 2yr swap spreads as interest rates.  Then, you buy the EURUSD as the implied exchange rate goes below the historic mean.  Buying the dips in this manner is a mean reversion play.  And in the current environment, this is a huge issue.

Why?  The problem with this trade is simple: the Fisher equivalency assumes that credit risk is constant between countries.  Now let’s look at the CDS implied data in the chart.  Looking at a variety of documents out there, you can see that assumption does not hold. Before there was a recognition on the part of traders everywhere that these credit risk issues are in fact somewhat differentiated, this trade made sense.  There’s a rate differential between the ECB and the Fed, and based on return expectations, you would have expected the Euro to outperform the dollar.  And as the Alphaville post points out:

The weakness of quantitative models (in general) aside, this is usually fine except for a couple things. For a start it’s been forcing the EURUSD to trade within a very specific range — exactly what the eurozone doesn’t need right now. Plus, the swap spread hasn’t decreased by very much since Germany continues to do reasonably well — or at least better than Greece and its porcine brethren.

In short, the quant model is at once increasing the cracks in the eurozone, and cracking.

Hmm… and as the chart shows, the ski slope down is a lot less steep now than it was 4 months ago:

Part of it has been reaction to the plethora bailout announcements, but part of it could also be model driven because a lot of people probably believe that if a bailout package is used, the credit problems go away.

They don’t.  They just get delayed.  The real issues are left to another day.

But as I pointed out earlier, the Alphaville post mentioned that these algorithms are buying on dips.  Conversely, if folks start readjusting their algos to sell on the rips (i.e. selling at peaks after a  run-up), there’s another issue:

It points to renewed waves of selling which will force the Euro lower.  The feedback loop can work in both ways: exaggerate buying action on the upside but also exaggerating the selling action to the downside.

One other thing that I think this trading system may have touched – Treasury auctions:

At the end of the day these auctions had decent outcomes, but the question is whether or not they should have been stronger.  In my mind, I think that if the Euro was weaker (i.e. we had an algorithm breakdown and selling had taken the Euro lower), the bids for Treasuries would’ve had stronger reactions due to the perceived credit worthiness of the US on a relative basis.  In other words, the flight to quality bid would’ve played a bigger role.  I haven’t done the research into this yet, but it’s an interesting avenue to explore.

But that will have to wait.  I have another, more ambitious post to put together…

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What? No Pawnbrokers in Downtown Athens?

I guess not.  Word is that the stars are aligning for a bailout of Greece from someone, but it’s not official as of yet.  But that hasn’t stopped the chanting for one.

“They have to be given some help from Europe or the IMF at concessional rates,” billionaire investors George Soros said in an interview on Bloomberg Radio today in Cambridge, England. “It is a make or break time for the euro and it’s a question whether the political will to hold Europe together is there or not.”

via EU Says It’s Ready to Aid Greece as Fitch Cuts Rating (Update1) – Bloomberg.com.

Soros has it all wrong.  In fact, he’s about as wrong on the Euro as he was right on the pound.  No amount of help is going to help the Greeks here.  Especially if the chart in this post at Zero Hedge is remotely accurate.  Pawnbrokers could probably give them a better deal on short-term money. Or what about those car title shops?  You know the ones: you need $1,000 for a week, they take the title to your car until you pay them back.  Plus interest, of course.

Just don’t walk in to the pawnshop with those 2yr, 5yr, and 10yr bonds.  They don’t do that kind of lending.  The deed to the Parthenon isn’t going to sway them.  Would they take health care equipment from the hospitals?  Don’t know, tough to say.  It’s certainly more liquid than the Parthenon.

But back to Soros.  An IMF/EU loan will just prolong the decline of the Euro, acting as a headwind to the original intent of the EU: fiscal policy and monetary policy discipline to prevent the ravaging effects of inflation upon a fiat currency.  A concessional rate loan would bring on pressures of a different kind: a devaluation of the currency.  Indeed, the long-term macro set-up is a devaluation no matter how it occurs.

Reuters is now out with a story that may be spelling out terms that could find their way to a term sheet:

A second source confirmed the rate would be more than six percent. Both noted the calculations were complex, because they were based on a three-month Special Drawing Rights rate that needed to be converted to 3-year rates using swap rates.

According to the formula, there would also be an extra 300 basis points on top of the SDR rate and an additional 50 basis points service charge.

For loans over 3 years maturity, there would be an additional 100 bps penalty charge, the first source said.

via Euro zone would charge Greece more than 6 pct-sources | Reuters.

So what are we looking at?  SDRs are the “currency,” and the rate is a swap rate (remember, swaps are a play on fixed vs. floating rates) based on the expectation of where the 3mth SDR denominated swap rate is 3 years from now.  How?  By coming up with a fixed rate based on dollar, pound, yen, and euro denominated 3yr swap rates blended together.  It’s not easy to understand, and hell, I may have gotten it wrong.  So by no means treat what I’m saying here as gospel.   But you can calculate the rates and the curve collectively based on the today’s 3 month rate and other inputs.  For those so inclined, you can read more about swap curve construction here:

So here we are, going into what some described as a Paulson-style weekend, only for a sovereign instead of a bank/financial institution.

That reminds me: I need to check the FDIC website.  I expect it won’t be quiet for much longer.

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Swap Spreads Go Negative as Carry Traders Continue Running In Front of Buses to Pick Up Pennies

A lot of thoughtful commentary and analysis has been put out there this past week on swap spreads going negative this past week.  Good examples can be found here and here.  Well I’m going to throw in my two cents on the subject as well.

In trying to analyze the issue, I pulled data from the Federal Reserve to look at spreads at various points along the yield curve and compared the average swap rate each day to its equivalent constant maturity Treasury.  The following two graphs show this in two ways.  First, I looked at swap spreads for the 2, 3, 5, 10, and 30yr swaps to Treasuries through time.  While all the talk this past week was about 10yr swap rates going negative to Treasuries, they have been negative for at least 6 months at the 30yr:

Since I also wanted to view swap spreads as a yield curve in their own right, I wanted to see what the term structure of swap spreads looked like.  This was even more telling in some ways.  Not only is it negative sloping, note the degradation and shift in this term structure in the past month:

The only things I can think of that would have had such a profound effect on this curve was the Fed’s “extended period” phrase being left in after the last FOMC meeting and we had a bad Treasury auction.

But as I look at these charts and data, I can’t help but think both of the dominant theories about this phenomenon are at work.  In the near term in the 2s,3s, and 5s we have swap spreads that seem to be moving together both in direction and in the size of the spreads.  The fact we’re seeing all of them move lower in unison speaks of extreme market complacency in the near term – confidence that adjustable rates will remain super low and fixed keeps grinding lower in the process.  Again, the image of kids carry traders picking up pennies in front of oncoming buses comes to mind.

But at the 10 & 30 yr, things seem to be different.  There, I think David Merkel of the Aleph Blog may be on to something:

And this:

Which is what I also tend to believe.  I think this is more about a Treasury glut than it is a credit risk issue.  Because governments can tax and they can print more currency.  Debt issuance is not the same as issuing currency because debt is borrowed.  Currency isn’t.  Defaults in a sovereign context really have to do with the tendency of a government to do a strategic default on its debt.  Think of strategic defaults on mortgages except bigger.  Other events can serve as a proxy for default like IMF/World Bank assistance, or currency devaluation.

So given those are the default definitions we have to work with, can we really say the US is going to do one of those things?  It’s hard to imagine them doing so, but there is no such thing as a zero probability event.  Over a long enough timeframe, anything can occur.

But as great as it is to imagine all of this, the big question is what will the rate curve look like going forward?  I don’t know, but Dr. Donald van Deventer from Kamakura Corp. illustrated their 10yr forward forecast of the Treasury yield curve:

The thing I note? The compression of the curve.  At the left (i.e. present day) you can see a nice upward sloping curve.  But as you move right, you see the curve is being forecasted to get tighter and tighter, with most of the increase coming in the short maturities/front-end.  Call this another “tell” that the market is being too complacent.  If they were more focused on the idea that the curve’s shape can change, they wouldn’t be looking to gain extra basis points off the present shape, but would consider what else could happen.

Oh well.  Just don’t come crying to me if it all goes wrong…

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