Analysis: Australia's imbalanced swap market is creating pockets of price chaos

Analysis: Australia’s imbalanced swap market is creating pockets of price chaos

SINGAPORE/SYDNEY, Nov 8 (Reuters) – Volatility has soared in an obscure but important corner of Australia’s interest rate derivatives market, valued at $113 billion a day, with disruptions affecting fixed income products .

Dealers say the generally stable market for the exchange of fixed and variable rate payments has gone wild due to a combination of policy changes, speculation and skewed flows.

Banks and corporations use the market to manage interest rate risk and traders depend on it as a benchmark for pricing other assets.

All were affected by the dramatic increase in the cost of swaps relative to bonds and liquidity quickly dried up.

“It is now much more difficult to make large trades in the wholesale market than it was three to six months ago,” said Mark Elworthy, head of Australia and New Zealand rates trading at Bank. of America Securities in Sydney.

“Transactions that would normally take minutes could sometimes take days to execute.”

It has also caught the attention of policy makers, although it is unclear what tools, if any, authorities might use to restore a functioning market.

To complete a trade, market participants turn to a broker or bank to facilitate the transaction. For a premium, participants can transform fixed income or liabilities into floating exposures, or vice versa.

No one is certain of the exact trigger, but the generally reliable relationship between this premium and government bond yields broke down in October and early November.

The spread between the two rates reached its highest level in a decade for the two main maturities and the “bond-swap spread” moved at its fastest pace in years.

Benchmark bond yield spreads over three-year and 10-year swaps reached ten-year highs last week, with the three-year exceeding 65 basis points and the 10-year flirting with 80 basis points, before to step back abruptly.

This 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 the bond swap spread.

Non-government bonds make up a fifth of the widely followed Bloomberg Australia Composite Index (.BACM0) and are likely marked against swaps, Elworthy said.


Part of the problem is the lack of supply in the bond market. Australia’s central bank holds around a third of sovereign debt, thanks to its massive monetary stimulus through bond buying during the pandemic.

This scarcity has now made bonds relatively more expensive, which means lower yields.

Meanwhile, swap rates moved the other way as dealers sought to limit their own exposure to interest rate risk, especially as markets were caught off guard by changes in the tone and outlook of the Reserve Bank of Australia as it raised interest rates.

Most of the theories offered by traders as to what caused the disruption relate to money flows, particularly from Australia’s big four banks, but also hedge funds that have been caught off guard by the moves.

Andrew Lilley, chief interest rate strategist at Sydney-based investment bank Barrenjoey, said the removal of a central bank liquidity facility this year is also a factor.

The so-called Committed Liquidity Facility allowed banks to swap less liquid assets for cash with the RBA.

Its withdrawal means that institutions are now scrambling for high-quality assets, mostly fixed-rate semi-government debt, as liquid capital for prudential purposes.

These new bond holdings then need to be hedged, which Lilley says has boosted demand for fixed income stream trading by 50% more than usual, which in turn is causing the market to explode. gap between bonds and exchanges.

Last week, the RBA’s head of domestic markets, Jonathan Kearns, noted the malfunctioning of the swap market.

“I think we always have to be very careful,” he told a forum in Sydney.


Other factors include a relative dearth of foreign debt issued in Australian dollars, which would normally generate demand for receipt when issuers swap their liabilities for their home currency.

Hedge funds also appear to have stepped in to try to take advantage of market dysfunction, but were also caught off guard, market participants said.

“People who had tried to play the widening may have been arrested leading to this messy widening,” said Jack Chalmers, senior rate strategist at ANZ.

The global backdrop hasn’t helped either, with Britain’s public debt collapse in September causing companies to “freak out for cover”, according to Robert Hong, head of bond credit in Asia at the StoneX financial services company.

To be sure, there are no major signs of spillovers to banks’ funding costs or broader financial markets. Other exchange markets around the world are also not experiencing similar pressures.

But the rapidity of price movements has raised concerns about skewed supply and demand flows.

“We generally think that interest rate derivatives markets have a very elastic supply,” Lilley said. “But now it’s behaving a bit more like a commodity market. While we’re getting small changes in demand, we’re getting extremely large changes in price.”

Reporting by Tom Westbrook in Singapore and Stella Qiu in Sydney. Additional reporting by Rae Wee in Singapore. Editing by Sam Holmes

Our standards: The Thomson Reuters Trust Principles.

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