BIS Warns The Fed Rate Hike May Unleash The Biggest Dollar Margin Call In History

[whisperer]

Today, in its latest quarterly report,the Bank of International Settlement focused precisely on this latest market dislocation. According to the central banks' central bank, "recent quarters have witnessed unusual price relationships in fixed income markets. US dollar swap spreads (ie the difference between the rate on the fixed leg of a swap and the corresponding Treasury yield) have turned negative, moving in the opposite direction from euro swap spreads (Graph A, left-hand panel)."

Given that counterparties in derivatives markets, typically banks, are less creditworthy than the government, swap rates are normally higher than Treasury yields because of the additional risk premium.Hence, the negative spreads point to a possible dislocation. One set of factors relates to supply and demand conditions in interest rate swap and Treasury bond markets. In the swap markets, forces that can compress swap rates include credit enhancements in swaps, hedging demand from corporate bond issuers, and investors seeking to lock in longer durations (eg insurers and pension funds) by securing fixed rates via swaps.

In cash markets, in turn, upward pressures on yields stemmed from the recent sales of US Treasury securities by EME reserve managers.The market impact of these Treasury bond sales may have been amplified by a second set of factors that curb arbitrage and impede smooth market functioning. First, the capacity of dealers’ balance sheets to absorb rising inventory may have been overwhelmed by the amount of US Treasury bonds reaching the secondary marketin the third quarter (Graph A, centre panel), causing dealers to bid market yields above the corresponding swap rates. Second, balance sheet constraints may have made it more costly for intermediaries to engage in the speculative arbitrage needed to restore a positive swap spread.Such arbitrage is sensitive to balance sheet costs because it requires leverage, with a long Treasury position funded in the repo market.

Meanwhile, while US swap spreads hit record negative levels, in Europe the market tensions have been of a different nature:

Ten-year swap spreads started to widen in early 2015, around the time when the Swiss National Bank abandoned its currency peg, then increased further over subsequent months (Graph A, left-hand panel). While past episodes of widening swap spreads can be attributed to credit risk in the banking sector, the most recent developments may have more to do with hedging by institutional investors. While swap rates also fell (Graph A, right-hand panel), the swap spread widened, indicating that cash market yields fell by even more. One possible explanation is that, as yields fall amid expectations of ECB asset purchases, institutional investors with long-duration liabilities, such as insurers and pension funds, would have been under pressure to extend their asset portfolio duration by purchasing additional longer-dated bonds, possibly compressing market yields below the swap rates.

[myname]

FED is going to get a margin call? That I would like to see