Rates reversal

Interest rate veterans may have privately enjoyed watching the credit markets suffering difficulties last year. That's because, despite being by far the largest asset class in the $400 billion-plus over-the-counter derivatives market, profitability from rates has been relatively low compared with fast-growing synthetic credit volumes.

At the same time as fixed-income investors lost most of their appetite for structured credit, sharp moves in interest rates around the world sparked more volatility in the asset class, providing interest rate structurers with the potential for extracting better returns for investors than have been seen for many years.

But it appears the profitable days for the interest rates market have already suffered a setback. The rapid inversion of the euro curve - where the 30-year swaps rate was less than the two-year rate for the first time caught out a lot of banks, especially those in the eurozone. One high-level fixed-income banker in Hong Kong at a eurozone bank put collective mark-to-market losses at around EUR3 billion.

Part of the reason for the big losses was the sheer speed of the inversion on June 5. Typically the other dominant interest rate curve - the dollar curve - flirts with inversion for several weeks, which provides more time to reduce position sizes.

But what has this got to do with Asia and the institutions that operate in the region? Apart from institutional and corporate exposure to eurozone interest rates through bonds and swap contracts, many structured products have been sold throughout the region in the form of 'steepeners' - bets that curves will steepen.

These products are now deep underwater, with investors losing billions of dollars on a mark-to-market basis. And this may fuel more probes by supervisors. As our cover story explains, structured derivatives products are under investigation in India. And there is talk that the Chinese banking regulator is looking into the sale of constant maturity swap trades in mainland China.

Rate moves in Japan have also caused major problems. The popular 'box trade' where so-called smart money had parked its cash for several years unravelled in March, losing billions of dollars for investors and causing hedging problems for the large underwriters of long-dated Japanese government bonds (see page 28).

One senior Tokyo-based risk manager at a bulge-bracket investment bank likened the situation to 1998. While the market has calmed down, JWM Partners, a hedge fund run by John Meriwether - of Long-Term Capital Management notoriety - reportedly lost hundreds of millions of dollars.

So credit, currencies, equities and now interest rates have faced turbulent times. What's next?

Christopher Jeffery.