Banks May Face Billions In Losses On European Interest Rate Trades

Investors positioning across many markets consistently face the acute question of which trade best expresses a given macro view, whether it is a change in overall economic growth, inflation or central bank expectation, including the latest and unexpected shift in European interest rates.

With investments banks and hedge funds facing billions of dollars in losses and writedowns, thanks to a complex European interest rate, currently at issue according to WSJ are so-called “steepening” trades.

From everyday experience traders and investors know that in general, the simplest tactical trade is often the most efficient. Trading macro views through money markets, curves, swap spreads and commodity futures often generates higher and more consistent risk-adjusted returns than positioning in equities.

With this perception in mind, steepening trades were seen as a no-brainer given the credit crisis. However, just months after problems with sub-prime mortgages and structured credit appeared to be easing the subject through steepening trades – has gained again center-stage. The losses this time are directly connected to this type of interest rate derivate, in which banks and fund managers make bets that long-term interest rates will rise in relation to short-term rates.

After the credit crisis took hold, these type of trades became rather popular as investors assumed central banks would have to lower their short-term interest-rate targets to cushion the impact of the crisis on the economy, while growing concerns about inflation would push up longer-term rates.

However, June 5 comments made by Jean-Claude Trichet, president of the European Central Bank, hinting an interest rate hike at its next meeting on July 3, led to a sharp inversion of the euro swaps curve, where short term rates were unusually far higher than long term ones, prompting this way a reversal of these trades and consequent losses in dollar terms.

Some market participants estimate the total losses in the past month at as much as $5 billion. A head of sales at an investment bank in Hong Kong, said one hedge fund, and potentially more, had lost $1 billion alone one the trade in early June. A derivatives structurer at a US bank in London described the losses on these products as “the new writedowns”.

Worth pointing out is that banks and hedge funds make a wide range of investments, some of which could benefit from the curve inversion and offset the losses. Also, even $5 billion is not a huge amount when spread across the entire universe of banks and investors around the world.

“It’s not like someone is going to come up with 2 billion euros in write-downs,” says Laurent Fransolet, head of European fixed-income research at Barclays Capital in London. “I would be surprised if the most impacted player would have more than a couple hundred million euros (of losses) on that sort of stuff.”

Still, the losses are likely to hurt at a time when banks are already reeling from heavy write-downs on mortgage and other investments. A disruptive effect, at least, will be felt.

Until recently, 30-year interest rates in the market for euro swaps hadn’t fallen below two-year rates since the introduction of the euro in 1999. Ten-year rates had last been below two-year rates in the early 1990s, before the introduction of the euro.

Since June 9, the curve inversion has become less pronounced – a factor that could mitigate the losses. On Wednesday, the difference between the 30-year rate and the two-year rate had narrowed to 0.38 percentage points, and the difference between the 10-year and two-year rates had narrowed to 0.28 percentage points.

Analysts note that many banks and investors have made new bets aimed at limiting their losses on the steepening trades. As a result, their positions are now hedged, which will dampen any losses if the curve inverts further. However, the new danger would be a reversal, where long term rates rise rapidly above short term rates.

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About Ron Haruni 1067 Articles
Ron Haruni is the Co-Founder & Editor in Chief of Wall Street Pit.

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