Undeterred, hedge funds bet on euro swap steepeners

Expected rate cuts and pension reforms are driving steepener flows, but large pension funds may not be finished hedging at the long end

Hedge-funds-pile-into-euro-swap steepeners

Hedge funds are returning to a popular rates trade despite uncertainties over inflation and Dutch pension reform.

Dealers report a renewal of interest in euro swap steepeners, which aim to profit from a widening gap between the fixed rates on short-dated and long-dated interest rate swaps. 

In particular, traders are taking a punt on the spread between 10-year and 30-year swaps, known as 10s30s. This basis is likely to widen if central banks cut interest rates later this year, as expected.

“In January… you’re having people creating steepeners in 10s30s betting on a rate cut,” says a euro rates trader at a European bank.

However, experts point out that rate cuts are by no means guaranteed, especially if inflation remains stubbornly high. Also, hedging activity by large European pension funds could depress the long end of the rates curve, jeopardising the steepener trade.

“If you prefer steepeners in 2s10s or 5s10s, that’s fine. But if you’re placing steepeners at 10s30s, there is a risk of pension funds just receiving the long end making the curve flatten no matter what,” says the rates trader.

These fears were borne out last November, when an indexation announcement by the second-largest Dutch pension fund caused the curve to temporarily flatten, prompting some firms to hurriedly unwind their steepeners.

The basis between 10-year and 30-year euro swaps has shown no clear trend since the start of the year. On January 1 the spread was -16 basis points, moving to -25bp on January 19. It has since retrenched to -19bp.

At the moment, rate cuts are being priced into new swaps, says the euro rates trader, but attention is on upcoming inflation data. Inflation in the eurozone rose from 2.4% in November to 2.9% in December, official figures show.

“You have to keep in mind that if inflation starts rising again and the central bank does not cut rates and you have a steepening position in place, you will have completely messed up because the market is reversing against you all the way,” the rates trader says.

Most of the demand for the trade is from hedge funds, but banks and some asset managers have also been putting on steepener positions, the trader says. 

Adding to this picture is the ongoing preparations as part of Dutch pension fund reforms which are set to come into force in January 2028. Many pension funds are adopting a defined contribution model where payouts are based on member ages and contributions, replacing the defined benefit model. Such a move is expected to result in pension funds no longer needing to use ultra-long swaps to hedge liabilities, reducing the number of fixed-rate receivers at the long end. 

There’s an expectation that if these large Dutch pension funds stop receiving the fixed rate at the 30-year to 50-year maturities, it will greatly steepen the curve at the long end and benefit those with steepener positions.  

A senior rates trader at one large dealer says it also has seen interest for steepener trades in recent weeks, but demand has been tempered by ongoing uncertainty around the future of the Dutch pension fund reforms. 

Parliamentary elections at the end of 2023 in the Netherlands saw gains for several far-right parties, which had voted in 2022 against the pension fund reforms. The parties won 37 out of the 150 available parliamentary seats, sparking concerns about the fate of the reforms and ongoing preparations for the move. 

But as the reforms were put into law on May 30 last year, a senior rates investment manager at a large Dutch pension fund says the political parties would need to form a coalition in government to adjust the law, meaning the hurdles for change are substantial. 

Dutch-parliament-building-in-The-Hague
Recent Dutch election results have thrown doubt on upcoming pension reforms

In the meantime, some Dutch pension funds have stopped hedging at the long end in anticipation of the shift, but other pension funds may need to extend their existing long-dated hedges, says the rates investment manager. 

“I can definitely plot a few scenarios where the overall hedge of the pension funds should even be expanded when they move to the new regulatory framework. This might be expanded more in the 10-year and 20-year sectors, and less for the 30-year, but that’s different to what some non-Dutch market participants are expecting, that all the pension funds are selling their 30-year exposure,” says the rates investment manager.

“I think it’s a bit of a gamble what these guys are doing,” he says. 

Extension of existing hedges depends on a number of factors, such as a fund’s current coverage ratio which determines the future payouts that members will receive. In the case that interest rates remain high and there is a high amount of capital in the fund, the expected future payout payments will also be high, potentially even higher than the current payouts members receive, says the rates investment manager. So, if the fund wants to hedge a part of that liability, they will need to expand their existing hedge instead of decreasing it. 

With these elements to factor in, the rates investment manager says any discussion around putting on steepener positions “is pretty short sighted”. 

Editing by Alex Krohn

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