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| June 25, 2008 11:17 a.m. EDT | |||
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| DOW JONES REPRINTS    This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit:www.djreprints.com. • See a sample reprint in PDF format. • Order a reprint of this article now. Yield Curve Whipsaws InvestorsBy RENEE SCHULTES, WILLIAM WRIGHT and NEIL SHAH June 25, 2008 11:17 a.m. LONDON -- Investment banks and hedge funds could be facing billions of dollars in fresh losses this quarter thanks to an unexpected shift in European interest rates, bankers and analysts say. At issue are so-called "steepening" trades, in which banks and fund managers make bets that long-term interest rates will rise in relation to short-term rates. The trades became popular after the credit crisis took hold, 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. But in early June, European Central Bank President Jean-Claude Trichet undermined such trades with surprise comments suggesting the central bank would raise rates in July -- a move that caused long-term interest rates to fall sharply below short-term rates in a rare event known as a yield-curve inversion. "Steepening trades were seen as a no-brainer given the credit crisis," says TJ Lim, chief executive of debt adviser NewSmith Financial Products in London. He said that since Mr. Trichet made his comments, there has been a "reversal of these trades, probably at big losses." Some market participants estimate the total losses in the past month at as much as $5 billion. To be sure, 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. "It's certainly had a disruptive effect," says Meyrick Chapman, Eurozone rates strategist at UBS in London. Banks, hedge funds and other investors typically made steepening trades in the market for interest-rate swaps, where investors buy and sell contracts that allow them to bet on the relationship between long-term and short-term rates. Banks and brokers have also made more exotic bets, such as options that require them to make payments only if long-term rates fall below short-term rates, or if the difference between the two moves out of a given range. It was on such bets that banks incurred a large portion of their losses, traders and derivatives experts say. 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. But after Mr. Trichet's June 5 comments, in which he confirmed that the ECB could raise short-term rates "by a small amount" at its next meeting on July 3, the swaps market went awry. Over the next three trading days, the 30-year euro rate fell to a 0.97 percentage points below the two-year rate. The ten-year rate, which had slipped below the two-year rate in early May, fell to 0.75 percentage points below the two-year rate – the largest yield-curve inversion on record. "Nobody ever imagined it could invert," said Kara Lemont, head of rates and FX structuring at BNP Paribas in London. "The assumption has been that the US Fed would cut rates and the ECB would follow." 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. "The big mess will probably resume when the swap curve will disinvert," says Arnaud Bornet, fixed income strategist at Fortis in Brussels. "
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