13 September 2015
(Extract from pages 14-15 of BIS Quarterly Review, September 2015)
Over the past year, asset prices in some markets have persistently deviated from levels that would be consistent with the absence of arbitrage opportunities. Such distortions can occur when scarce funding or limited balance sheet capacity prevents investors from taking advantage of the resulting trading opportunities. This is often the case during financial crises. More recently, reduced market liquidity and central bank actions may have played a role. This box examines three prominent examples of dislocations.
Deviations from covered interest parity, which in the textbook view should normally be eliminated through riskless arbitrage, have been trending up for major currency pairs. The deviations were especially high for the Swiss franc after the Swiss National Bank discontinued its minimum exchange rate against the euro (Graph B, left-hand panel). Covered interest parity implies, among other things, that FX forward discount rates embedded in the price of FX swaps should be equal to the interest rate differentials between the currencies involved in the swap. Differences between money market rates and interest rates embedded in FX swaps often signal funding difficulties in one of the currencies. For instance, as unsecured US dollar funding markets became increasingly dysfunctional during the financial crisis, foreign banks with large dollar funding requirements increasingly turned to the FX swap market to obtain dollar funding, which in turn pushed FX swap-implied dollar interest rates far above dollar Libor rates.
The more recent spread widening between dollar interest rates derived from the FX swap market and those in the Libor market has also tended to favour the swap counterparty supplying dollars. However, this has probably reflected derivatives market imbalances, rather than funding difficulties of the kind seen during the height of the crisis. On the demand side, institutions such as non-US pension funds and insurance companies, which have large dollar asset positions but liabilities that are predominantly denominated in the local currency, may have ramped up their holdings of dollar bonds and their hedging activities. Such increased hedging needs may be linked to the recent increase in FX volatility (Graph 1, right-hand panel). On the supply side, financial intermediaries' ability to supply hedging instruments such as FX swaps has remained subdued, as they have significantly reduced their leverage since the financial crisis. As a result, they have been willing to devote balance sheet space in order to meet the increased demand for dollar swaps only in return for a considerable premium.
Such demand imbalances in FX swap markets have been reinforced as borrowers have reacted to changes in funding costs for dollars vis-à-vis other currencies. As major central banks outside the United States have ramped up their unconventional easing efforts, funding conditions have loosened considerably in key foreign currencies. As a result, US corporations have increasingly been issuing debt in foreign currency, including the euro (Graph 9, right-hand panel), and this may have further increased the demand for swapping into dollars.
Another dislocated market segment was that of inflation-linked bonds. Large gyrations in euro area break-even inflation rates (that is, inflation rates that would make the overall return on an inflation-linked bond equal to that of a comparable nominal bond) have highlighted the importance of liquidity premia for index- linked instruments. Because the nominal yield curve contains information about inflation expectations and risk premia, nominal interest rates can be used to track the variation in break-even inflation. The close relationship between the two broke down from the end of 2014 (Graph B, centre panel), as five-year break-even rates derived from inflation- linked bonds implied significantly lower inflation than the measure based on nominal yields only. This coincided with a fall in index-linked bond turnover reported by debt management agencies, suggesting that rising liquidity premia in index-linked bonds had driven their yields up and therefore pushed down measured break-even inflation rates. When the ECB announced and started implementing its expanded asset purchase programme, which explicitly included index-linked bonds, break-even inflation rates recovered sharply, possibly overshooting. The ECB actions therefore appear to have been perceived as significantly reducing illiquidity in the index-linked market segment, thus sharply reducing the liquidity premia required by investors. This suggests that variations in liquidity premia rather than shifts in inflation expectations were a key driver of euro area break- even inflation rates during this episode (Box 1 further discusses bond market liquidity developments, focusing on German government bond markets).
The negative policy rates introduced by several European central banks in 2014 and 2015 have also created distortions in some market segments, in particular when non-bank players have been involved. Across the affected countries, banks have so far been reluctant to pass on negative rates to retail depositors. This has exposed them to higher funding costs and additional interest rate risk. Swiss evidence suggests that banks have factored the lost revenue and hedging costs into the pricing of new mortgages, which led to an increase in the 10-year Swiss fixed mortgage rate, even as money market rates moved deeper into negative territory and government bond yields fell (Graph B, right-hand panel).
See eg N Baba and F Packer, "From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers", Journal of International Money and Finance, no 28(8), 2009, pp 1350-74.