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Tuesday, June 10, 2008


intense curve flattening

the synopsis of the past couple days' action from across the curve:

Prices of Treasury coupon securities have registered losses in overnight trading with the 2 year note suffering a particularly large calamity. The yield curve has flattened rather dramatically in response to comments by Federal Reserve Chairman Bernanke in which he noted that risks of a substantial economic downturn had diminished. I think it noteworthy that the Chairman even chose to downplay the significance of the weak labor report on Friday and instead chose a holistic approach in which he observes that all the data taken in their totality have affected the outlook only marginally. And he burnishes his credentials as an inflation fighter by declaring that “the Committee will strongly resist erosion in long term inflationary expectations”. So his comments, in concert with the harsh rhetoric from ECB President Trichet last week, have added to the damage at the front end of the yield curve.

These movements and twists in the yield curve are watershed events and represent the collective judgment of market participants that an increase in the funds rate is a far more likely possibility than anyone would have thought possible even a week ago. So the price action in Europe and here has resulted from the jettisoning of long established positions anticipating a steeper yield curve. The violence and suddenness of the move has also forced some to unwind positions as technical levels are breached or as losses flow freely from hemorrhaging positions. I think that liquidity remains impaired and to exit large positions is a more difficult exercise than it was pre-August 2007. I am sure that given the generally debilitated and risk averse environment that risk managers will take a harsh view of large losses in core proprietary trading positions.

these are some of the largest one-day moves in a decade -- the curve steepening bet is probably one of the most common in credit markets given the agressiveness with which the fed had previously moved to liquify markets using negative real rates. as mish notes, that trade blew up yesterday -- and it is a highly leveraged one. jason goepfert:

Are we going to now be hearing about funds going under that had put on leveraged curve steepeners?

good question -- but more broadly: the american economy is weak, assailed by impaired banks, a collateral crunch, record energy pricing and a nascent recession. and yet, the fed is being forced to consider raising rates -- that is, becoming procyclical as opposed to countercyclical for the first time since paul volcker was leading the fed.

with the credit backdrop frequently being called the worst of the postwar era -- see minyanville's bennet sedacca today -- is it really such a reach to reference 1931?

UPDATE: macro man says it pithily -- "There is something very, very wrong with financial markets at the moment." and further:

What we're seeing is a complete and utter meltdown in fixed income exotic structures. These structures entail payouts depending on the shape of yield curves, and are extremely popular in Europe. Typically, the holder of the structure will earn a payout if yield curves are above a certain level x, but nothing if below. Against this, they may a floating rate such as LIBOR/Euribor.

Against this, the issuing bank will have curve steepeners on as a hedge. The problem arises when the curve flattens/inverts; not only does the holder of the structure lose money, but the issuing bank must take off some of its steepening hedges. All of this is fine for the bank in a marketplace offering a continuous liquidity spectrum. However, these banks are short gap risk and can find themselves badly offside if curves flatten (i.e., intensify their inversion) without and de-hedging activities taking place.

Such is the case at the moment, where the euro 2-10 swap curve has flattened 50 bps in 3 days, a move that has not been reciprocated in other major markets. This bodes ill for European financials, and Macro Man is frankly surprised to see European equities only slightly in the red this morning. He's responded by adding to shorts there.

alea too has noted the jump in the overnight index swaps, implying that the "next Fed move is UP and not just 25 bp."

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