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The interest rate derivatives market of the homeland of kangaroos is showing peaks of volatility. Could this be a problem for the entire Pacific region with a combined volume of $113 billion a day?
Intra-market stock dealers report that the normally stable fixed-floating exchange market has become unmanageable due to a combination of policy changes, speculation and distortions. This small but critical segment is used by banks and corporations as an indicator to manage interest rate risk, and traders rely on it as a benchmark for valuing other assets.
And all of them were victims of a sharp jump in the value of swaps in relation to bonds. At the same time, liquidity quickly dried up, which, it seems, is already becoming a characteristic feature of the times.
Right now, it is much more difficult to close a big deal on the wholesale market than it was even three to six months ago, at the moments of a major drawdown of world indices. Transactions that usually take a few minutes can sometimes take days.
Of course, this hits all market participants, ruining the most active ones (non-government bonds make up a fifth of the widely monitored Bloomberg Australia composite index).
To make a swap, market participants turn to a dealer or a bank for assistance in a transaction. For a premium, participants can turn fixed incomes or liabilities into floating risks, or vice versa.
No one can now say how it all began, but the usually reliable link between this premium and government bond yields broke in October or early November. Suddenly, the gap between the two rates was the biggest in a decade for major instruments. At the same time, the "spread for an exchange for bonds" was moving at the fastest pace in recent years.
Yield-to-swap target spreads for 3-year and 10-year bonds jumped to ten-year highs last week, with 3-year bonds topping 65 basis points and 10-year bonds attempting to gain 80 basis points but pulling back sharply, leaving market participants bewildered.
The resulting confusion has resulted in higher hedging costs for banks and corporations, and mark-to-market losses for portfolios that hold debt at a price relative to bond swap spreads.
Obviously part of the problem is the lack of supply in the bond market. Australia's central bank holds about a third of sovereign debt thanks to massive monetary stimulus bond buying during the pandemic. That is, here we are seeing how the problem that the Fed faces is gradually spreading to other markets. True, here it is reversed exactly the opposite: an excess of demand, not supply, makes the markets suffocate.
This deficit has now made bonds relatively more expensive, which also means lower yields.
All in all, the dealers decided not to lose on low yields, so they raised swap rates in an effort to limit their own exposure to interest rate risk, which increased as markets were caught off guard by changes in the tone and forecasts of the Reserve Bank of Australia as interest rates increased.
This is what lies on the surface. However, the market usually regulates itself. Why didn't this happen?
Most of the theories that deserve attention point to the fact that a large amount of money was withdrawn from the big four Australian banks, as well as from hedge funds, and the markets were misled by these movements. This seems to be true, especially given that the Russian oligarchs have chosen Australia as a hub for their hard-earned money.
But other experts add that the winding down of the central bank's credit line this year is also a factor. And this also seems to be true ... although the Australian economy does not seem to need stimulus, especially against the backdrop of the same influx of Russian funds.
But there is a nuance.
The so-called Guaranteed Liquidity Fund allowed banks to exchange less liquid assets for cash with the RBA.
This conclusion means that institutions instead are now trying to get high-quality assets, mostly fixed-rate semi-public debt, as liquid capital.
These new bond investments then need to be hedged, which seems to have pushed the demand for fixed income flow swaps up to 50% more than usual, which in turn narrows the gap between bonds and swaps.
Not without reason last week, the head of the RBA Financial Stability Department, Jonathan Kearns, noted the dysfunction of the swap market.
Analysts noted other factors: the relative shortage of foreign debt issued in Australian dollars, which usually causes demand when issuers exchange their obligations for their national currencies.
Hedge funds apparently also intervened to try to take advantage of the market dysfunction, but according to market participants, they also failed. But they spurred a wave of chaos: trying to play on the expansion of swaps, they lost control, and the expansion became uncontrollable.
The global background was also unfavorable: the collapse of the British government budget plan forced companies to hastily hedge risks.
To be sure, there are no serious signs of a spread to the cost of bank financing or broader financial markets. Similar pressure is not seen in other swap markets around the world.
However, the speed of price movement has raised concerns about the skewed flow of supply and demand. Especially given the Fed's difficulties in the same segment. We usually think of interest rate derivatives markets as highly elastic supply. But now it is showing signs of a commodity market. This, in general, is typical for speculative markets. Now, when demand is experiencing a minimal correction, in the end it causes prices to move chaotically. This really reminds me of the recent history of nickel speculation on the London Metal Exchange.
The scale of the problem is so large that it has already attracted the attention of politicians, although it is not clear what tools the authorities could use, if any, to restore a functioning market. Part of the problem is that dealers don't want to give up their risk fees, and that's understandable. But derivatives are getting cheaper, and how these commissions could be covered is not yet clear. Obviously, the market, as always, will correct itself, but at such times, all these systemic errors slowly begin to crawl out, suddenly ruining entire clusters of traders... and making others richer. The risks have really increased, and who would want to miss out on their benefits?
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