"It's what you learn after you know it all that counts."
John R. Wooden
Expert A: WRONG – int swap beyond 3 years are traded on a SPREAD BASIS meaning there is a cash bond trade IMEBEDDED. I did these trades. Lots of times I had to find the bonds so my trades could happen.
I’ve written many paper on this.
Hedging Mechanics of Interest Rate Swaps > 3 yrs. Duration
Interest rate swaps > 3 yrs. in duration customarily trade as a "spread" - expressed in basis points - over the current yield of a corresponding benchmark government bond. That is to say, for example, 5 year interest rate swaps [IRS] might be quoted in the market place as 80 - 85 over. This means that the 5 yr. swap is "bid" at 80 basis points over the 5 yr. government bond yield and it is "offered" at 85 basis points over the 5 year government bond yield. Let's assume that 5 year government bonds are yielding 1.90 % and the two counterparties in question consummate a trade for 25 million notional at a spread of 84 basis points over. Here are the mechanics of what happens: The payer of fixed rate pays [1.90 % + 84 basis points =] 2.74 % annually on 25 million for 5 years. The other side of the trade - the floating rate payer - pays 3 month Libor on 25 million notional, reset quarterly - typically compounding successive floating rate payments at successive 3 month Libor rates so that actual cash exchanges are settled "net" annually. To ensure that the trade remains a "true spread trade" [and not a naked spec. on rates] and to confirm that 1.90 % is a true measure of where current 5 year government bond yields really are - the payer of the fixed rate actually buys 25 million worth of physical 5 year government bonds - at a price exactly equal to 1.90 % - from the receiver of the fixed rate at the front end of the trade. So, in this regard, we can say that 25 million IRS traded on a spread basis creates a "need" for 25 million worth of 5 year government bonds - because it has a 5 year bond trade of 25 million embedded in it.
- Interest rate swaps of duration < 3 years are typically hedged with strips of 3 month Eurodollar futures instead of government bonds.
In recent years the Chicago Mercantile Exchange [or CME] has developed an interest rate swap - futures based hedging product for the 5 and 10 year terms. I acknowledge the existence of these products but due to their 200k contract size and amounts traded, as reported in archived CME volume data, they do not materially impact the numbers in this presentation.
As demonstrated, Interest Rate Swaps create demand for bonds because bond trades are implicitly embedded in these transactions. Without end user demand for the product – trading for “trading sake” creates ARTIFICIAL demand for bonds. This manipulates rates lower than they otherwise would be. In short, there are not enough U.S. Government bonds IN EXISTENCE to adequately “hedge” J.P. Morgan’s interest rate derivatives book. That’s why we can deduce that these interest rate derivatives are, in fact, the “undeclared” [stealth] central plank of U.S. monetary policy.
Expert B: There were tens of trillions in IR swaps (which incidentally are NOT in any way used in the Treasury market but only to convert fixed to floating and VV) when neither banks nor the fed were loaded to the gills with USTs. There is no synthetic linkage between the UST market and the IR swaps market. If on the other hand you can show a direct correlation between Treasury swaptions and rates then I would be all ears as that is precisely the way the refexive relationship between USTs and a derivative could be impacted.
Expert A: I think you should re consider your assertion. Why don’t you give me a good reason why 5 institutions are taking hundred of trillions worth of settlement risk [bonds settle T + 2] in an environment where they allegedly are afraid to lend overnight funds to one another and interbank lending has virtually come to a standstill???
There are no end users for virtually ANY of this hundreds of trillions in notional trade.
Due to this, bond trades are very difficult to even settle and there are customarily HUGE amounts of “fails” every month:
papers.ssrn.com/sol3/
In this study (an update and revision to our 2007 working paper), we estimate the total value of trade settlement failures in the US bond markets. Analyzing data from multiple sources, we show that the value of settlement failures is rising. Regulatory and market efforts to reduce the problem have been largely unsuccessful. In April 2008 fails todeliver in bond m
No, I don’t feel that my explanation is weak at all. I brokered and documented int. rate swaps off a bond desk that I started for about 8 years. I know what goes into doing these trades. This is a CIRCLE JERK of unthinkable proportions. I think you need to think about it a little bit longer.
Expert B: The assumption that IR swaps is there to simulate UST demand is very week absent aLOT of additional proof.
Expert A: I’ve heard this guy on tv before and he sounded like he knew what he was talking about. However, in this article – HE IS WAY OFF BASE: He states:
“If U.S. finances were really as bad as the commentariat suggest, and have been suggesting for decades, Treasuries would be in freefall.”
This is pure rubbish. The US is insolvent. Interest rates are rigged beyond belief. Market rates of interest should be and historically have been set at the real rate of inflation plus 200 – 250 basis points. We know that real inflation rates are running at approximately 6 % [see John Williams – Shadow Stats – work].
That would put the BASE for market rates of interest for government securities at somewhere near 8.5 %.
So why aren’t rates that high?
The reason:
OTC interest rate swaps [highlighted in yellow] maturing beyond 3 years HAVE REAL CASH GOVERNMENT BOND TRADES IMBEDDED IN THEM. A very substantial portion of the 120 Trillion identified in the yellow box [principally held by 5 institutions who are VERY close to the FED / Treasury] ARE interest rate swaps maturing in more than 3 years. This int. rate swap edifice acts as a HUGE sponge that soaks up an unbelievable amount of physical government bonds creating artificial scarcity.
We know that these trades can only be for nefarious reasons BECAUSE the Office of the Comptroller of the Currency [OCC] tells us there are NO END USERS for these trades [this is really misdirection because the real “end user” is the Fed to effect U.S. Monetary Policy.
The maintenance of the int rate swap edifice [which at its root is a high frequency bond trading mechanism] creates staggering volume of paper trades in bonds [like the LBMA creates untold volume of trade in paper metal trades] which artificially “SETS THE PRICE” of capital at arbitrary levels.
Sorry Mr. Tamny, THIS IS WHY an insolvent institution like the U.S. Government is able to “borrow” [if you can really call buying your own debt borrowing] at low rates.
It’s the biggest CON JOB the planet has ever seen.
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