Hedge funds retreat to sidelines in euro steepeners

Rate hike repricing and stop-losses have gutted positioning in once-dominant 10s30s bet

Key points Summary Q&A

• Ongoing war in the Middle East and surging gas prices have wiped out most hedge fund positioning in the euro interest rate swap steepener trade.
• The 10s30s spread fell from a peak of 33.5 basis points on December 3 to roughly 10bp by March 6, then plunged to 0.5bp on March 24 as markets priced in European Central Bank rate hikes.
• Hedge fund stop‑outs also upended a trade that assumed a widening in the Euribor-€STR basis. Instead, it went from 9bp on February 27 to 3bp on March 9.
• Tom Prickett, head of G10 rates trading for Emea at Citi, estimates only around 25% of the steepener trade remains with speculative accounts.
• Dutch pension funds, though, say the recent moves will not affect their transition plans.

These summaries are generated by an LLM, but edited by humans.

Recent market moves driven by the ongoing Iran conflict have wiped out most remaining hedge fund positioning in the euro interest rate swap steepener trade – once considered the biggest concentration of risk on the Street.

“Whatever is left of that steepener trade is probably quite residual compared to two weeks ago, where there had been significant risk reduction,” says a head of euro swaps trading at a European bank.

The trade profits from a widening of the spread between the 10-year and 30-year (10s30s) euro swap fixed rate. Dutch pension funds’ expected unwinding of long-dated swaps hedges, no longer needed because of ongoing reforms, looked set to steepen the curve by removing structural demand for long-end receiving. The 10s30s spread went from flat in May last year to a peak of 33.5 basis points on December 3.

But surging gas prices following the outbreak of hostilities in the Gulf sent short-term inflation expectations soaring and narrowed the spread from around 30bp on February 27 back to roughly 10bp by March 6, triggering stop-losses for many hedge funds along the way.

 

When markets priced in future European Central Bank rate hikes on March 23, the 10-year rate moved higher still relative to the 30-year point, bringing the 10s30s spread down to 0.5bp by March 24, causing more pain for those still in the trade.

“People were hoping the repricing would be short-lived and they had enough ammo to keep the trade on,” says the euro swaps head. “But we’ve repriced more than three hikes for this year. That was the straw that broke the camel’s back, so I feel like everyone’s kind of given up,” he adds.

Tom Prickett, head of G10 rates trading for Europe, the Middle East and Africa at Citi, estimates that “around 25% of the steepener trade is still held by speculative accounts” despite the recent moves, however. 

The 10s30s spread had increased back to 4.5bp by the London morning of March 25.

Other buy-side sources believe the trade was responsible for a sizeable portion of reported macro hedge fund losses from the conflict.

Basis pain 

Hedge funds were also burnt on a related expectation that the basis between long-dated swaps referencing the risk-free euro short-term rate (€STR) and those based on six-month Euribor would widen. As Dutch pension funds stop receiving fixed on long-dated Euribor swaps, the reduced flow was expected to push the €STR-Euribor basis wider.

The theory was that with pension funds’ long-dated receive-fix/pay-float swaps being in-the-money to the dealers, that value was sensitive to changes in the overnight rate at which the swaps are valued, in this case €STR. So, dealers have discounting hedges in place that see them receive €STR and pay fixed.

Activity in general has been lower, even though volatility has been higher

Fabio Broecker, BNP Paribas

When the pension funds unwind their long-dated swaps to transition to the new regime, for example by doing offsetting pay fixed Euribor swaps, that would increase the Euribor swap rate. At the same time, dealers can take off their discounting hedges, which would see them enter offsetting receive-fix €STR swaps that would drive down the €STR swap rate and widen the basis to Euribor swaps.

But the hedge fund stop-outs on the steepener trade saw funds having to close out their positions by entering receive-fix Euribor swaps, pushing the Euribor swap rate down toward the €STR swap rate, and narrowing the basis. This tightened the 50-year €STR-Euribor basis materially, from 9bp on February 27 to 3bp on March 9.

With the trade being particularly illiquid at the very long end “you could really feel the pain in the re-tightening,” says the euro swaps head. 

The basis has since widened to 6bp as of March 25.

Headline risks

The steepener trade reached peak positioning last summer. But by September many hedge funds chose to unwind positions after banks lowered their estimates of how much pension funds would need to reduce excess long-dated swap hedges.

Some large hedge funds with strong conviction around the steepening theme kept faith with the trade over year-end, however. Dealers told Risk.net in February that around 80% of the positioning remained.

Related

Steepeners whipsawed by Dutch pension scheme shifts 

Hedge funds stopped out on euro steepener amid Iran conflict 

Hedge fund holdouts boost euro steepener bets into year-end 

Euro overnight index swap markets are now pricing three 25bp rate hikes by December – in stark contrast to the 50bp of cuts priced on February 27. The euro swaps head says that while the risk of rate hikes remains live, the curve will not steepen meaningfully.

Dealers say headline volatility around a potential de-escalation of the Iran conflict means conviction on macro risk is low.

“I don’t think there’s much risk deployed because there’s such a risk to any headline that there’s no good risk-reward being in any linear trades,” says the euro swaps head.

“A lot of macro funds have given up, will wait for the dust to settle, get a clearer picture of where we’re going and then reset some trades if that makes sense at some point.”

Hedge funds that were stopped out of short positions in UK and European inflation swaps have also been sitting on the sidelines. “The busiest period was two weeks ago. Activity in general has been lower, even though volatility has been higher,” says Fabio Broecker, co-head of European inflation trading at BNP Paribas. 

“People are more cautious about the risk they put on,” he adds.

Jasper Valstar, a senior portfolio manager for liability-driven investment funds at Achmea Investment Management, says it is unlikely the moves will influence Dutch pension funds’ plans on unwinding their excess swap hedges.

A rates trader at a Dutch pension fund manager also says the effect of the market moves on funds’ transition plans “has been fairly limited” so far.

The largest fund, ABP, with more than €500 billion ($587 billion) in assets, is expected to move to the new framework on January 1, 2027. 

But BNP Paribas research suggests that pension funds transitioning in 2027 – which have a funding ratio of around 123% – could see that buffer pared back meaningfully if equities declined by a further 20% alongside a 50bp drop in 20-year swap rates.

Editing by Lukas Becker