How the Iran war is fuelling wild swings in interest-rate bets

[WASHINGTON] The Iran war has clouded the outlook for inflation and economic growth across the globe and, in turn, where interest rates might be heading. 

The uncertainty is stirring volatility in interest-rate swap markets, where traders wager on what central banks will do next. Rate bets in the US and Europe have been swinging wildly, changing by the minute as the conflict in the Middle East continues.

A lot of attention is paid to swap markets as a gauge of rate expectations. When investors shifted their view from two quarter-point rate cuts from the Bank of England this year to as many as four such hikes, this was gleaned from swap market pricing.

However, there’s more nuance to swap market activity as traders are not just placing purely directional bets; some are also hedging against swings in borrowing costs.

Fluctuations in swap markets have a broader significance as well. The movements ripple across asset classes, including stocks and bonds, and can also affect mortgages and government budgets. 

What are interest-rate swap markets?

Traders are constantly trying to predict the path of central bank interest rates. One of the main ways to track those expectations is through interest-rate swaps that are tied to risk-free overnight borrowing rates – benchmarks that represent the cost of borrowing cash between banks overnight and move in line with central bank policy rates.

These swaps are linked to central bank decision dates and entail an exchange of interest payment streams between two parties over a set period.

If an investor agrees to pay a fixed rate while receiving a floating one that moves with daily borrowing rates, they’re betting on a central bank rate increase. If they choose to receive a fixed rate while paying a floating one, they’re betting on a central bank rate cut.

As traders take these positions, the fixed rate adjusts until supply and demand balance – in other words, buyers and sellers agree that this is where central bank rates will be over a specific period.

That doesn’t mean this collective view should be taken as gospel. Swap market pricing often fails to accurately capture the full scale and speed of actual interest rate moves.

Looking at the UK’s response to the Covid-19 pandemic, for example, it’s clear that traders were slow to bet on how many rate hikes would be needed to cool inflation, and then overshot with their expectations when rates stabilised.

Who uses swap markets?

Banks, asset managers, hedge funds and companies use swap markets to either make speculative bets on central bank policy, or to protect themselves against future interest-rate swings.

Take a company with a floating-rate loan, where its interest payments increase if central bank rates go up. To offset this risk, the firm can enter a separate interest-rate swap contract, typically with a bank, whereby it pays a fixed borrowing cost but receives a floating rate in return.

Similarly, an investor with a large portfolio of bonds may want to hedge themselves against the risk of higher central bank rates, as bond prices fall when interest rates rise. If they enter a swap contract to receive floating rates, they’ll profit if interest rates move higher, offsetting the losses on the bond portfolio.

Hedge funds often operate with a much shorter time horizon than companies using swaps for hedging purposes. These funds may therefore seek to take advantage of the volatility in swap markets to place wagers on the speed and size of interest rate moves.

Why have US, UK and European rate bets been so volatile recently?

Since the Iran war began, some markets have swung from anticipating rate cuts to pricing in several hikes.

The main driver has been uncertainty over how far central banks will need to go to tame inflation as the conflict disrupts the supply of energy and other commodities out of the Middle East and pushes up prices.

At the same time, some investors are starting to focus on whether the crisis might eventually slow economic growth and force central banks to reduce interest rates.

European and UK swap rates have seen the most aggressive repricing as their economies are heavily dependent on energy imports and more vulnerable to big shifts in oil and gas prices. The European Central Bank and Bank of England also operate under a primary mandate to maintain price stability, whereas the US Federal Reserve has a dual mandate to promote both stable prices and maximum employment.

Swings in interest rate bets are often exacerbated by traders getting caught on the wrong side of a wager, forcing them to liquidate their position, typically at a loss.

Why do swap markets matter?

Swings in rate expectations ripple across asset classes because interest rates are the foundation for how almost everything is valued.

For equities, valuations are often based on the present day value of expected future cash flows. If interest rate hikes are seen as likely, those future cash flows are worth less today.

Rate expectations also feed through to the real economy.

If a central bank is expected to increase rates, investors will demand a higher yield on bonds to entice them to part with their cash, making it more expensive for governments to borrow and refinance their debt. That frequently translates to higher budget deficits and could prompt cutbacks in spending on public services.

In some countries, swap rates also affect the housing market. In the UK, fixed-rate mortgages typically hold the interest rate steady for two or five years, and swaps help determine the rates that banks offer.

Volatility can make it difficult to accurately price loan offers. A spike in swap rates since the start of the Iran war has triggered a number of lenders to pull products from the UK market, reducing the choice for homebuyers.

Mortgages in the US work differently. Rather than being linked to swap rates, standard 30-year mortgages are closely aligned with the yield on 10-year Treasuries.

In general, volatility in swap markets makes it much harder for households, businesses and governments to plan.

But central banks can benefit. If swap markets are priced efficiently, the changes they induce in the real economy can do some of a central bank’s work for it, tightening or loosening conditions and reducing the need for policy action. BLOOMBERG