Origins of `Bund Tantrum' Seen in Interest-Rate Swaps, BIS Says

  • Rising costs of euro rate-hedging preceded correction
  • BIS points to `reduced market depth in cash markets'

The rout in euro-area sovereign-bond markets in April and May that shook markets around the world may have had its roots in derivatives.

The probable cause was a rush by investors in preceding months, when securities prices were rising, to protect themselves against falling yields using swaps, according to the Bank for International Settlements. The cost of options to enter a swap contract on a future date -- to fix a rate of payment -- rose by a factor of three from early 2015 to April 20, as 10-year swap rates declined, the BIS report said.

Options got relatively expensive amid speculation the European Central Bank would increase monetary stimulus to the region, driving rates down further. The fact that banks struggled to satisfy this hedging demand from institutional investors, such as insurers and pension funds, highlights an enduring investor concern over market liquidity.

“This year’s turbulence in fixed-income markets may have had its origins in derivatives and hedging activity, with reduced market depth in cash markets exacerbating the spillovers,” Suresh Sundaresan and Vladyslav Sushko wrote in the BIS report published Sunday. “Such volatile movements in euro-area interest rate derivatives markets raise questions about smooth pricing responses in the face of possibly transient order imbalances.”


Hedging Costs

The rising costs of euro rate-hedging preceded the correction in German bond yields at the end of April. That’s when 10-year bund yields surged from almost zero to near 1 percent in a matter of weeks in what the BIS has called the “bund tantrum.” The rout spread across global fixed-income markets until June.

Tumbling euro-region bond yields re-emerged this month. Before the most recent policy meeting on Dec. 3, short-dated yields on many of the region’s notes, including Germany, France and Spain, fell to record-lows.

The ability of traditional options writers, such as banks, to help provide liquidity in hedging markets is being called into question, Sundaresan and Sushko wrote. In April, the rising demand to receive fixed-rate payments via swaps may have been met by a lack of counterparties on the other side of the trade who would have needed to be willing to receive floating-rate rates.

Price Relationships

“Unusual price relationships” have been witnessed across fixed-income markets this year, the reports authors added.

In the U.S., dollar swap spreads have turned negative. Normally, swap rates are higher to take into account the additional risk premium, considering counterparties in derivatives markets are banks, not governments, which typically are considered safer. 

In the euro-area, swap spreads have widened as cash-market yields have fallen faster than their respective swap rates, a trend that began when the Swiss National Bank abandoned its currency peg in January. Falling market yields would have been compounded by institutional investors hedging against lower yields by buying longer-dated bonds to extend the duration of the assets in their portfolio, BIS said.

The decline in swap rates was eased after the ECB’s announcement on Thursday to increase stimulus by 360 billion euros ($392 billion) and cut the deposit rate by 10 basis points disappointed many investors. In the aftermath, 10-year bund yields jumped 20 basis points, the most since November 2011, narrowing the swap spread.

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