Monday, June 09, 2008
Well, that was an enjoyable weekend respite, wan't it? Wonderful warm, sunny weather, which suited Macro Man down to a T, as he had sole charge of the Macro Boys for the weekend. After a week of the sturm und drang of financial markets, it was refreshing to deal the calmness and rationality of two children with the combined age of 11.
However, it's once more unto the breach this morning, and after Friday evening's equity market meltdown, the market's exhibiting signs of extreme dislocation again today. The theme of 2008 seems to be that if the day ends in y, somebody, somewhere is blowing up.
Today's carnage comes courtesy of European fixed income markets. Obviously, the short end received a rather rude jolt from the ECB on Thursday, but at least a recalibration of the very front end of the yield curve makes rational sense. It's hard to conjure a fundamental explanation why Trichet's hawkishness should have prompted a massive rally at the back end of the European curve, but that's exactly what's happened. German 30 year yields have collapsed 30 bps in 2 days, a remarkable move in any context (US 30's have had a 2 day, 30bp move exactly once in the last dozen years), but particularly when the central bank surprises hawkishly.
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.
Among the biggest perpetrators are French banks, so perhaps M. Sarkozy will legislate that every day should be Sunday (the only day of the French week that does not end in "i"); for the time being, however, anyone involved in the European exotics market is surely humming the Boomtown Rats this morning.