Authors: Tom Westbrook and Stella Qiu
Article: Original article
Publication date: Tuesday, November 8, 2022
There has been a surge in volatility in Australia's $113 billion-a-day interest rate derivatives market segment. The dealers report that the normally steady market for fixed- and floating-rate exchanges has gone wild because of a combination of monetary policy changes, speculation and skewed flows.
Banks and corporations use the swap market to manage interest-rate risks, and traders rely on it as a benchmark to evaluate other assets. They have all suffered from the surge in the value of swaps relative to bonds, and liquidity has quickly dried up.
"Getting large trades done in the wholesale market now is much more difficult than even three-to-six months ago," said Mark Elworthy, head of Australia and New Zealand rates trading at Bank of America Securities in Sydney. "Trades that would normally take a few minutes could sometime take days to execute."
That has also drawn the attention of policymakers, although it's also unclear what tools the authorities might use to get the market back on track. To make a swap, market participants turn to a dealer or bank to facilitate the transaction. For a premium, participants can turn fixed incomes or liabilities into floating exposures, or vice versa. The usually reliable link between this premium and government bond yields broke down in October and early November.
The gap between the two rates shot to its widest in a decade for the two main tenors and the bond-swap spread has moved at its fastest pace in years. Yield spreads to three-year and 10-year bond swaps jumped to ten-year highs last week, then pulled back sharply. This has meant higher hedging costs for banks and corporations, as well as market value revaluation losses for their portfolios.
Part of the issue is a lack of bond market supply. Reserve Bank of Australia holds about a third of sovereign debt, thanks to its massive bond buying monetary stimulus during the pandemic. This shortage has now made bonds more expensive, which means lower yields.
Meanwhile, swaps rates have moved the other way as dealers seek to limit their own exposure to rate risk, heightened as markets have been caught off-guard by shifts in the Reserve Bank of Australia's tone and outlook as it hikes interest rates.
Andrew Lilley, chief interest rates strategist at Sydney-based investment bank Barrenjoey, says the winding down of a central bank of its credit line this year is also a factor of instability. The so-called Committed Liquidity Facility allowed banks to swap less liquid assets for cash with the RBA. Now instead, banks are trying to get high quality assets, mostly fixed-rate parastatal debt.
The global backdrop has also been unhelpful, with September's meltdown in British government debt sending companies "panicking to hedge," according to Robert Hong, head of fixed income credit in Asia at financial services firm StoneX.
So far, there are no serious signs of this chaos spreading to the cost of bank financing or the broader financial markets. Other swap markets around the world have not seen similar pressure. But the speed of price movements has raised concerns about skewed supply and demand levels.
"We usually think of interest-rate derivatives markets as having highly elastic supply," Lilley said. "But now it's behaving a little bit more like a commodities market. As we're getting small changes in demand, we're getting extremely large changes in price."
While Australian financial market volatility has not yet reached the scale of the September panic in the U.K., such warning signs will keep increasing pressure on the nation's currency.