財經觀察 1538 --- USSS30YR: More troubles emerge

The –ve USSS30yr has also got attention by FT again. We are not alone.

Couple of points highlighted in the article:

1)       Market disallocation after LEH fall

2)       Worries over the US Deficit

3)       Poor liquidity due to Bank’s balance sheet

4)       Pension Fund US swap as synthetic trade for cash preservation

5)       Exotics hedging: Power Reverse Dual Currency notes

More troubles emerge among derivatives

By Michael Mackenzie in New York Published: November 18 2008 02:00

Further stress emerged in the long-term US interest rate derivative market on Monday, with the latest episode of pain coming from impaired exotic trades based on the Japanese yen.

The 30-year swap spread traded around minus 20 basis points, the most extreme level yet seen since the market became dislocated in the wake of Lehman Brothers' collapse in September. The swap spread should normally trade in positive territory as it reflects the risk premium of trading with a private counterparty above a US Treasury yield.

Investors use swaps to lock in interest rates for 30 years or more, trading a floating rate, based on the London Interbank Offered Rate, for a fixed rate. A negative swap spread implies investors believe that the credit of a private counterparty is better than the US government.

However, the dislocation in the market is a function of poor liquidity as banks conserve their balance sheets ahead of the year ending. Meanwhile, pension funds and other long-term investors are using swaps, rather than buying bonds, which reduces their cash reserves. The negative turn in spreads is compounded by exotic trades backfiring in the current risk-averse environment.

Strength in the yen has sparked a need by banks to transact 30-year swaps in order to protect their positions. That has helped drive the spread further into negative territory and has also pulled the 10-year swap spread sharply tighter over the 10-year Treasury yield. A week ago the 30-year spread was trading at 1bp and last week had reached minus 16bp.

"The 30-year spread market continues to be dominated by exotics hedging desks needs with some effects into 10-year spreads," say UBS . "Our advice . . . get out of the way or get run over."

The bank said hedging needs from so-called Power Reverse Dual Currency notes have increased as the yen had rapidly appreciated in value.

The notes allow Japanese investors to gain higher yields from the 30-year money market, while being paid in yen.