Lynn Strongin Dodds looks at the role of derivatives against the backdrop of geopolitical risks, inflation and interest rate rises
In a matter of months, predictions for 2022 were upended. Instead of rising inflation and interest rates abating by year end, levels are now expected to be at record highs due to the ongoing war in Ukraine. No one predicted the Russian invasion and ensuing human tragedy which continues to wreak havoc on markets. As with other periods of volatility, derivatives have a role to play but this time market participants are proceeding with caution.
The volatility looks like it is here to stay. In its latest Financial Stability report in May Financial Stability Report – May 2022 (federalreserve.gov) the Federal Reserve warned of deteriorating liquidity conditions across key financial markets amid rising risks from the war in Ukraine, monetary tightening and high inflation in a semi-annual report published recently
“According to some measures, market liquidity has declined since late 2021 in the markets for recently-issued U.S. cash Treasury securities and for equity index futures,” the U.S. central bank said in its Financial Stability Report.
“While the recent deterioration in liquidity has not been as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal,” the report said. “In addition, since the Russian invasion of Ukraine, liquidity has been somewhat strained at times in oil futures markets, while markets for some other affected commodities have been subject to notable dysfunction.”
Jeffrey O’Connor, senior execution consultant, Market Insight Analyst, US Equities at Liquidnet, believes that the next catalyst is the earnings season which is currently underway. There is a hope in the US that big tech will save the day and offer relatively high valuations against the economic pressures of the war and the impact of surging inflation on household finances.
“There is a lot to digest – interest and inflation rates going higher, and the ongoing geopolitical situation,” O’Connor says. “But ultimately, that’s not what people focus on when it comes to their bottom line. They are unsure of the volatility spikes which is why cash is at high levels at the moment.”
Derivatives Trading Amidst Market Volatility
Traders did initially turn to derivatives to hedge the risks. As Tom Loffredio, head of business development at Derivative Path, said, “Broadly speaking, we saw an increase in hedging inquiries and activities across interest rates, foreign exchange and commodities in the first quarter from our financial institution and end-user clients.”
He adds, “We believe this to be partially a result of both uncertainty in the market outlook and the resultant volatility in these asset classes. Some of these moves – likely due to macro drivers such as higher levels of inflation and the changing expectations for US Federal Reserve rate hikes – were likely exacerbated by the situation in Ukraine.”
Swaptions have been the preferred route to mitigate the higher rate environment. This is particularly true during the pandemic when volatility and premiums were low. They are options on interest rate swaps (IRS), which give the buyer the right to enter into a contract in the future at a pre-determined price. Estimates are that this one segment accounts for roughly USD 490 trillion OTC interest rate derivatives market.
However, the mood has shifted as there is now a dearth of liquidity with bid/offer spreads widening. “We saw a lot of our clients put hedges in place last year. But if hedging is not a mandatory lending condition, some borrowers are choosing not to hedge at these levels because there has been a more than doubling in the premium cost of interest rate caps in two months in dollars, euros and sterling and that has caused some issues for transactions,” says Jackie Bowie, managing director, global real estate at Chatham Financial.
ISDA Steps In
The International Swaps and Derivatives Association Inc (ISDA) launched the 2022 Russia Additional Provisions Protocol in March to enable parties to amend the terms of Protocol Covered Transactions and Covered Agreements. This includes credit derivatives and CDS contracts referencing sanctioned Russian entities, such as Gazprom.
These new sanction provisions are needed to make these amendments to ensure that sanctioned debt does not interfere with a potential future CDS settlement process.
ISDA states; “The Protocol allows parties to update their legacy transactions to apply the new terms, maintaining fungibility between legacy and new transactions and ensuring that the Sanctions Order does not prevent legacy transactions from being included in any CDS Auction that might be held in future.”
Looking ahead, it is difficult to predict how the rest of the year will unfold although the general consensus is that volatility will be omnipresent and negative sentiment will remain. As Chris Iggo, chief investment officer for core assets at AXA Investment Managers, notes, markets remain bearish with April seeing little respite so far to negative returns across most liquid asset classes. Bond yields are moving higher still, credit spreads have widened again, and equity markets are, at best, going sideways.
“The S&P500 index has been in a 4200-4600 trading range since mid-January, and the NASDAQ,” he adds. “Composite has traded between 12500 and 14500. It’s a tough environment, as volatility has been quite high. The number of days the change in the US Treasury 10-year yield has been more than 10 basis points has been 8 so far in 2022 compared to 5 in the whole of 2021. For the 10-year Bund the numbers are 6 for this year compared to 1 in the whole of last year.”
As market volatility continues, derivatives market participants will continue to be kept on their toes and alert to the rapidly changing space.