Hungary central bank action ‘distorting’ swaps curve

The Central Bank of Hungary has offered up 1 trillion forint notional of cheap interest rate swaps, driving down bids for receiver swaps and government bond yields, say dealers

The central bank is keen to encourage lending to SMEs to boost the economy

An ambitious stimulus package from the Central Bank of Hungary – which is offering local banks up to 1 trillion Hungarian forint ($3.6 billion) in cheap interest rate swaps in a bid to boost lending – is having a sizeable distortive effect on the forint interest rate swap curve, say dealers.

The central bank introduced its monetary policy initiative – dubbed the 'interest rate swap conditional on lending activity' (LIRS) programme – at the end of January, offering commercial banks three-year forint fixed-for-floating interest rate swaps at rock-bottom prices.

Under the scheme, banks pay a fixed rate of between 10 and 13 basis points in return for a floating rate pegged to the six-month Budapest interbank offered rate (Bubor), Hungary's interbank lending rate, which stood at 135bp on February 17. Participating dealers must pledge to use at least 25% of the subsequent cashflows to increase lending to small and medium-sized enterprises (SMEs).

Dealers say the impact of the scheme has been felt immediately, but not in the lending market. "The short-term impact of the LIRS tender is definitely not in lending. The immediate impact is on the interest rate swap market. We have seen a distortion to the swap curve and there has been a strong effect on the government bond market. Yields have been pushed down and this will be a lasting phenomenon," says Zoltan Torok, head of research at Raiffeisen Bank in Budapest.

The first LIRS tender on January 28 attracted 11 bank participants, with 618 billion forint in notional volume parcelled out between them. A second tender on February 11 saw an additional 110 billion forint allotted to seven banks.

The flood of cheap swaps has depressed the bid rate for six-month Bubor swaps: the rate for three-year swaps fell from 148bp in the week before the first tender to 130bp on January 28 – a fall of 12%, according to data from Thomson Reuters (see chart). After the second tender the bid dropped to 127bp, marking a fall of 14% compared to the pre-LIRS mark.

Overseas clearing houses that clear forint swaps say they are closely monitoring the effect of the central bank's actions on their forint curves. A spokesman at CME, which clears forint swaps out to 11 years, said the impact should be positive. "This will hopefully increase liquidity in additional tenors, which should be good for the market," he said.

The Central Bank of Hungary initiated LIRS to compensate for the gradual phasing out of its near-three-year 'funding for growth' monetary easing scheme. It is expected that the swaps tender and other measures will increase lending to SMEs by 250-400 billion forint, according to a spokesman for the bank.

The initial allocation in January was set at 200 billion forint and was oversubscribed threefold as a result of "extremely intensive interest" in the facility, says the spokesman. The central bank intends to allocate a total of 1 trillion forint to the facility this year, though the spokesman adds that it expects the bulk of the demand to have been fulfilled in the first two tenders.

Regarding the impact of the scheme on the forint swaps curve, the spokesman says the drop in the bid rate was "limited". He adds that the central bank "constantly monitors forint interest rate swap market movements" and expects "no more substantial market volatility" in the wake of future LIRS tenders.

Dealers participating in the LIRS initiative are deploying the proceeds in a number of ways, says Attila Behan, head of trading at K&H Bank in Budapest. "The asset-liability desks at the commercial banks either sit on this position, or buy some government bonds to create an asset swap spread between the interest rate swap and bond, or close some part of this interest rate swap against the market," he says.

Yields have been pushed down and this will be a lasting phenomenon
Zoltan Torok, Raiffeisen Bank

Yields on three- and five-year Hungarian government bonds fell 10bp on January 29 as LIRS dealers piled into the instruments. The Central Bank of Hungary is said to be keen to boost banks' holdings of sovereign debt after foreign investors fled the market last year. Non-resident holdings of Hungarian sovereign bonds fell almost 25% from January 2015 to January 2014 according to AKK, Hungary's government debt management agency, meaning local banks will have to increase their appetite for the junk-rated paper if state funding targets are to be met.

The movement in the forint curve in the days immediately following the first tender suggest dealers are using their boosted interest rate swap inventories to compete aggressively on pricing fixed-for-floating swaps.

"I see no reason why anyone should sell fixed interest rate swaps below 1.35% because the floater is not going to go any lower than the 1.35% we are at right now. Bubor is pegged to the base rate of the central bank, which is at 1.35%, and the central bank cannot do much to move the Bubor from 1.35% artificially or naturally. I don't see what monetary tools could be used for that unless they decrease the base rate or introduce further measures regarding the three-month deposit system," says Behan.

Others argue the central bank's programme will bolster liquidity in the forint swaps market across longer maturities and minimise sharp variations in pricing.

"Traders say liquidity is always narrow in these markets. In my view, the LIRS programme will stabilise interest rate swap rates in the market, so when there is turmoil in international markets they would not jump around as much as they would without it," says Gergely Ürmössy, chief economist at Erste Bank in Budapest.

A research note from Citi published on January 28 suggested that if the global inflationary outlook shifts, the LIRS programme could help keep monetary conditions in Hungary loose by acting as a disincentive for the central bank to hike base rates. Raising rates would increase the spread between the fixed and floating legs of the swaps issued under LIRS, eating into the central bank's profit-and-loss account.

"Extending the tenors and the size [of LIRS] may be a risky strategy as the build-up of these positions would act as a disincentive to the Central Bank of Hungary to hike rates when inflation picks up. [But] this is not a concern in a global disinflationary environment, so risks seem to be manageable on the three-year horizon," says Eszter Gargyan, an economist at Citi Research in Budapest.