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Is there any value in interest rate futures?

20 April 2009

The Macro Trader’s view:

Although official interest rates in the leading economies have reached or are very close to zero, the short term interest rate futures markets:
Short Sterling, and
Have all failed to converge with official interest rate levels. This was due originally to the enormous LIBOR spreads which opened up in the early stages of the financial crisis, as Banks became petrified of lending unsecured money to each other in the wholesale money markets.
As one by one the largest Banks of the US, UK, Euro zone and Switzerland announced an almost endless round of very large losses, with almost eye watering amounts written off as loss provisions against bad debts, the money markets became almost dysfunctional.
And even today, normality hasn’t returned despite the recapitalisation of the Banking system and record low interest rates. Moreover, with economic recovery still mainly an aspiration rather than reality, one could be forgiven for thinking interest rate futures could even yet rally closer to official levels.
But we judge that unlikely to happen. Although several large US Banks have just reported solid profits and UK Bank HSBC had a successful rights issue, house prices in the US and UK continue to fall, with repossession rates in the US starting to rise again as the foreclosure moratorium expires.
Also Swiss Bank; UBS has just reported another large loss and is looking to shed labour worldwide, and with retail sales in the US once again in negative territory the current period of good news could prove a blip as the asset quality of the Banks could once again start to deteriorate and lead to fresh losses.
Far from this having a bullish impact on Short Term interest rates, it could have the reverse as LIBOR spreads widen out once more. Even if the reverse occurs and recovery takes hold, the Banks continue to report an improved profit environment short term interest rate futures still won’t rally, even though LIBOR spreads could quickly narrow, as the Central Banks will want to begin removing the massive liquidity they have collectively pumped into the system, which together with the equally massive fiscal stimulus, could if not drained in a timely manner, lead to an outbreak of inflation.
In all probability, these interest rate futures markets have seen the highs in this cycle and the next move is likely to be a Bear market. But until recovery is clearly underway and self sustaining, official interest rates are likely to remain at current low levels for an extended period, with Eurodollars, Short Sterling and Euribor consigned to a period of range trading.
So in summary, is there any value in Short Term interest rate markets? Not currently, but when the economy turns, there will be very good trading opportunities for the Bears as they start to probe the downside and seek to second guess the timing of the turn in official interest rates.

Mark Sturdy,
John Lewis
Seven Days Ahead

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