Alison Irvine
Hi guys. Thanks for joining in. I can see the numbers are still ticking up. So we'll just wait for one more minute before we kick off.
I will kick off there then. So hi everyone. Thanks for dialling in and welcome to another session in our Master Markets Master class series. My name's Alison Irvin. I'm on the sponsors risk management team here at Lloyds and today joining me is Luke Parker, who runs our interest rate trading desk. We're going to use the next 30 minutes or so to cover the interest rate curve its constructions uses and implications for funding so.
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So without much further ado, I will go over to Luke. So Luke, if you could start by briefly introducing yourself before we get into the content.
Luke Parker
Yeah, sure. Thanks, Allison. So I run rates trading at Lloyds within LBCM. So that's sterling dollars, EUR and various other currencies, interest rate derivatives, gilts, inflation options, cross currency and anything else related to interest rates. Really.
Alison Irvine
No wonder you're the busiest man alive.
So let's I guess if we get that your presentation up and we'll start with the basics. So I think most of us have seen how interest rates can vary with tenor, if only from the perspective of our kind of retail deposits or our mortgage rates. But it'd be great to know how you guys look at them in broader the broader financial markets.
Luke Parker
Yeah, sure. So hopefully you can see slides.
So I thought I thought I'd start with some of the instruments that actually trade in the market that we that trade most frequently and therefore we kind of base the yield curve that we build from. So you can kind of split the market into three areas. And two very clear areas. So this sort of like the short end and then the medium term and the long end. So short end, there are various instruments that trade in the market every day sort of minute, minute by minute.
Some exchange traded some OTC’s, so between banks and between clients, one of the key ones that many sort of outside of the direct market wouldn't necessarily know about are central bank swaps.
So those are interest rate swaps that start on the effective rate generally of a of a central bank meeting and end on the effective date of the next central bank meeting. And when we produce a yield curve, we assume that interface will stay flat between meetings. So there's no, you know there's no sort of accounting for potential intra meeting hikes or cuts and that's why if you look on the left there you've got flat lines in between those dots.
And you can see at the moment this has taken a few days ago. You know, we're in a sort of rate cutting cycle.
There's a a chance of rights cuts happening over the next few meetings, and if you look in the table on the top right, you can see when I took the snapshot anyway, where these were for the UK. So MPC swaps column and then one of the reasons that these are traded so sort of frequently is they are effectively can give you a sort of probability weighted chance of a certain amount of cut or hike at each meeting. So under that what's price column for example you can see at the time I took the snapshot there was.
19.3 basis points of cuts priced into the November 25 meeting. So that's just the difference between the September rate and the November rate. So just over a 50% chance that they've got 25 basis points and that's kind of how we look at those rates and think about them.
And then further out the curve.
The main rates that are traded in the market are spot interest rate swaps and gilts, and bond futures, and so we use different instruments to drive that part of the curve.
Alison Irvine
We. Yeah, I see. You kind of got 2 lines for those kind of longer dated instruments. What are the difference there between those two lines?
Luke Parker
Yeah. So the darker green line, the lower one is interest rate swaps and the lighter green line above is gilt yields.
So some of you may have heard about asset swap spreads or gilt spreads. That is basically the difference between those two lines. So the difference in yield between.
A gilt yield and the equivalent swap yield, so that's why we've got 22 lines there.
And they trade very differently for.
Different reasons. There's, you know, one is A is a derivative, one's a cash product with a payment at the end. So they're different accounts, accounting principles behind them. Different people use the different instruments and different supply and demand dynamics. So hence there's.
There's a difference between them.
And then I thought it might be useful to point out that.
Different sort of types of clients are more active in different parts of the curve. So as I said before, you can split it into three areas. Really there's the short end which most people would have out to sort of two or three years and.
It's driven almost entirely by where the market or pop market participants are expecting Central Bank meeting dates to settle or a probability weighted price of where they're likely to settle.
And the participants are sort of hedge funds and speculators betting, if you like, on what's going to happen at each meeting, but then also banks are very active because they have, you know, fixed term deposits, which are short term and sort of one year, two year, three-year mortgages, that's they might want to hedge and various financing transactions that you know last for three, six months, 12 months which have a directional impact on the market.
Either in swaps or in FX forwards, which then also influence the interest rate market directly.
And then in the middle of the belly of the curves we normally call it sort of three to 10 years or three to 12 years.
You have.
Much more sort of driven by supply demand dynamics. So the supply of corporate bonds or sovereign bonds, which are normally around the sort of three to five year area.
You have banks that are also active. Given we have, you know, kind of five year mortgages but also structural hedge flows from the large banks who are almost terming out the hedge for their deposits that they that they have. And then again it's a very active area for sort of hedge funds and asset managers.
And then in the long end, it's much more supply and demand driven.
Mostly how much sovereign bonds supply. There is. Some countries have a longer supply than others. The UK is particularly long in that regard, and pension fund demand, because that's generally the longest liability that's out there an average of sort of 2025 years. So pension funds tend to be very active in in that in that part of the curve.
Alison Irvine
Interesting. And for that for that kind of medium long end, is it always people kind of doing that outright swap to the seven-year or the 10 year point or are they are they trading things slightly differently?
Luke Parker
So. Not to get into too much of the detail, but yeah, different points of the curve trade in different ways. So generally, if you do a seven-year swap, you don't very often trade A7 year swaps directly in the in the market, in the street to hedge yourself, the curve is driven by more liquid points. So in almost every curve, it's the 10 year points, it's normally driven by. So in the UK for example, the most liquid part of the long end curve is the 10 year Gilt future.
And then the yield from that?
Plus the basis to give you the cash guilt plus the asset swap level that 10 year spreads are trading at will tell you where the 10 year swap rate is. So there's a kind of leg to get to the tenure rate and then something like the seven-year would actually trade as a curve to seven years or as a five year seven-year 10 year fly. So hence if you know if a if a client’s trying to do something in 60 or 70 year they might have a larger sort of hedging cost than if they're doing something in 10 year because the actual hedge that you would put on for that trade has more legs effectively.
More chance of slippage?
Alison Irvine
Yeah. Understood. God, that that sound confusing? It must be a very smart person that has to assemble these curves in various pricing systems.
Just before we go kind of move on though, I'm curious what's kind of going on at that very long end of the curve there. Obviously you've got fairly consistent spread between your swap and your and your bonds. And then right at the end it comes right back in again. And what what's that?
Luke Parker
Yeah. So that's the sort of convexity impact on the market.
The further out your cash flows are, the more that they're dependent on the discount rate. That's that you apply to them. So and as interest rates go higher, your discount also rate also gets affected. So there's actually value in holding longer term gilts just from the fact that they are so long because there's a large cash payment at the end. By owning the gilts, you're effectively long volatility or you've got some positive gamma, I should say.
So what does that mean? It means that as interest rates go up, the size of your position actually decreases.
And is great. Go down your size, increase it so it's there's some value in owning them rather than just whether they go up or down by themselves, and hence the price of them is higher. The yield of them is lower, so it makes the curve sort of roll over at the end there.
Alison Irvine
Interesting. Thanks. So yeah, so then we've kind of got an idea of all of the various different kind of instruments that can trade. What do we do with them?
Luke Parker
Yeah. So I mean, I should just point out that I've just picked out a few key instruments here. There are lots of others that, that, that trade in the market, futures and various other things that can feed into these curves. But I thought these are the most interesting ones.
And then what we do you said, you know, smart people build these models. Thankfully, that's not my job.
But generally, when you think about yield curve, your picture something like the chart on the previous screen where you've got a bunch of instruments with different maturities.
And different yields. But really the yield curve, as we think of it is a is a map of an interest rate or discount factor on everyday. So that you can effectively model any individual cash flow and therefore you can price you can price any instrument that's that that yield curve is calibrated to essentially.
And that's how we think about it this this kind of fully a full map of the full curve right from the sort of 0 to data.
Last day of 100 years.
And there's various different ways that you can build a yield curve. I don't want to go into.
Too much detail, because there's probably some very specific calls you can find out online.
About that, but key points are you have a bunch of different input instruments and rates which you want spread across the whole curve. As we saw in the last page, you then have to calibrate the curve, which essentially just means that whatever instrument you put in, you can kind of normalise them. So you can then apply an interpolation method to them and then one of the biggest things is really the interpolation method that you.
That you apply and these, you know, effectively mathematical formulas for interpolation. It's involved a lot over the years, but the reason it matters. I've got these two charts on the right, which I thought would demonstrate. So the top one is the discount factors for each day along the curve. So just to you know, you multiply if you've got a cash flow over 100 million in 40 years time, you multiply it by .18 and it gives you your value today based on that above.
And that looks really smooth on the face of it. But actually if you look at the yield curve in forward space, which we'll look into a little bit essentially looking at the yields for the that daily cash flow on that particular day.
That same set of discount factors using the same six different interpolation methods give you very, very different results in terms of the daily yield.
Through the full Interstate curve, as you can see by the, all of the squiggly lines on the charts on the bottom right. So it's very important to choose an interpolation method which gives you a smooth.
A smooth line there essentially. Otherwise you know a cash flow on one day is going to be a very different value to cash flow the next day where it's really you know if that's in 30 years time, they should be.
Very, very, very close to the same value.
Alison Irvine
And so you've obviously kind of pulled out six different models here. Who is it that decides on a kind of an institution picking one of those models?
Luke Parker
Good, good, good question. I guess it's the actual decision itself is a collective between quantum stretching teams trading.
But really, it's whatever you feel at the best model is to give you the smoothest, the most accurate curve for a given set of sort of instruments and cash flows and the environment or preferably an interpolation method that works in multiple environments. So you know that is your sort of your model that you then have.
For multiple years.
Alison Irvine
And then we'll use a similar model across kind of different currencies as well. Or do we have a different model per currency?
Luke Parker
So generally you'll have the same model across all of your, all of your interest rate curve interest rate curves.
Alison Irvine
Consciously. Oh, that's. And so then we've kind of got our nice smooth forward curve. I guess the kind of the question is, So what do we use those forward rates for?
Luke Parker
Yeah. So once you've got, once you've got this forward curve, you can then use it to, oh, excuse me, to look at things much more consistently and look at the history of certain instruments through time to do analysis around how they've behaved in different environments and different regimes.
So I thought I'd pick out four or five.
Forwards, in particular that people look at and I look at a lot.
And if you got a longer run history, then you know, as I say, you can see how these things behave during the financial crisis or during the, you know.
Sort of fiscal waves of 2022 or during COVID so.
The first one is one year, one year, which is essentially is a, you know, a summary and one number as to what's priced that we talked about earlier. So you know how many cuts are coming up.
Starting in 12 months time and for the 12 months following that, you've then got what we call two year one year. So just to be clear, that's a one year swap starting in two years time.
Which really is there from a macro level, it's sort of where's the yield going to end up after this current cycle? So you know, wherever two year one year is at the moment after the Central Bank has done all their cutting, that's kind of where the market is, right is pricing that.
Sort of terminal base if you like, and then a. Lots of people in the market look at five year, five year so five year swap starting in five years time. Why? Because it it's kind of after the current cycle but it's before the market gets dominated by the supply and demand of long end bonds. So it's kind of that sweet spot in the middle.
And it really gives you a good idea of where the market's pricing the longer term neutral rate for that economy or for that country.
Plus some term premier, which, although that has been negative in the past but plus some term premium for that particular country and then you can look at curves within that as well. So the two year one year versus five year five year spread you know from what I just said that's the where's the where's the rate going to end up after this current cycle?
Where should it be in the longer term and so therefore it's kind of how far away from neutral are we? Are we going to be at the end of this cycle? So that's very commonly looks at and we can look at an example of that through history later. And finally 10 year 10 year guilds.
Roughly speaking, although it has shortened over the last decade or so, the average pension fund liabilities are around about 20 year. The average duration of gilt issuance is around about the same. So looking at that forward, excuse me.
So looking at where that forward is gives you an idea of.
Where guilt yields are in that sort of sweet spot of being driven by supply and demand, it's also normally roughly where that sort of hump of the curve is. As you can see on the on the diagram on the charts on the screen now. So it's another thing that is closely watched. And by the way, I said when I say so, the WAM is the weighted average maturity of the of the of the issuance. So you know the overall size of each issue multiplied by the duration take the average and it tells you how.
How long the bonds last for on average, essentially.
Alison Irvine
Roughly where the kind of. Yeah, the UK's government bond markets kind of are on average, got you.
Luke Parker
Yeah, exactly, exactly.
Alison Irvine
And on so just on these kind of on your graphs that you've got, you've got all you've got, Sterling, you've got U.S. dollar and you've got EUR. It's so interesting to see kind of how closely they do all track. Is that what you mean by cross market mean reversion or and kind of how do people trade that then?
Luke Parker
Maybe we jumped. I've got some something on that on one of the later slides so.
And it's the next slide. So yeah, so an example of how this is looked at in the market from quite a few and traded by quite a few market participants. People will look at their five year five year spreads. It being that you know the best indicator we have of where the market's putting the neutral rate for that particular country looking at it, that's bit the difference between the five year five and the US compared to the five year five in the UK for example, which I've got charted on the bottom left there.
Many people will trade that within a sort of macro model on a mean reversion basis. So you know if it gets they will have a sort of Fair value for where that spread would be. And if you get too far away from that fair value, then they'll put on trade to you know, make money when it when it comes back. So as you can see since 2007.
That has oscillated around zero spent, spent much of its time with.
The with the UK below.
You can also sort of see different regimes in there as well.
So.
For example, in the last in the last few years you've had UK yields higher.
And many people will trade it from that basis as well. So it's not necessarily a mean reversion around zero, but it's a view on the on the longer run neutral rate between particular countries.
I thought it might be useful to look at another way that we sometimes use these.
Forwards so the sort of right hand side of this slide.
It's a sort of slightly a basic chart, but it tells you, tells you quite a lot. So if you imagine if I just popped out back to this previous slide so I don't know if my mouse pointer actually shows up on the screen.
Alison Irvine
We can. We can see that on my screen it's a bit small, but I can see it.
Luke Parker
Yeah.
So the low point of these curves is at a certain point in time in the in the future, if you, if you look at the, you know that the euro curve here it's quite soon and then and then we start coming back up again, it's a little bit later in, in, in dollars and a bit earlier but a bit sort of more kind of wider through in the in the UK.
That low point of the curve, this is basically a chart of where that low point is in the curve. So over the last couple of years it has been around sort of six or seven years from now.
Which?
Right now, as you can see by this chart, charts having come down here, it's quite soon.
If you're looking at something like this, then when you push out again and it gets round to the sort of five 6-7 year area, it kind of tells you that.
The curve is downward sloping for quite a long time, so if you're deciding between OND issuance and you're deciding between a three and a five year, for example, and you can use this to decide actually am I am I receiving actually the low point of the curve here in forward space or should I be shifting?
My issuance to a different part of the curve for indeed, if you're hedging your bond issuance, you may you may think about this kind of forward dynamic as well.
Gain some value.
Alison Irvine
Interesting. So kind of you know where if I want to pay or if I'm paying interest rates, I want to pay at the lowest point of the curve. But if I'm at the if I'm receiving interest rates, I probably don't.
Luke Parker
Exactly.
Yep, quiet.
Alison Irvine
Interesting. OK, great. Nice. Yeah, let's go on to the next bit.
Luke Parker
Yeah, I'm sure how we're doing for time, but I've got a couple more examples we could kind of race through and then get some questions.
Alison Irvine
Yeah, that sounds great.
Luke Parker
So what do we have here? Oh, yeah. So I mentioned 10 year, 10 year gilts before. So the chart on the left is 10 year 10 year cash in different. So it's German, US, U.S. Treasuries and gilts. And just to point out.
You know.
10 year, 10 year treasuries and gilts up sort of roughly the same levels now, but gilts is a little bit higher and we did spend all of sort of 2010 sorry 2016, 1718 with Treasury yields quite a bit higher.
And there's been a lot of talk recently of should the DMO shorten their issuance because there's no demand in the long end and yields have been pushing higher.
And I just thought that, you know, comparing 10 year, 10 year gilts versus five year gilts, for example, which is the charts on the right?
The difference between the two is actually around about the same level it has been for quite a long time, so the UK are kind of used to paying extra for having that longer Wham. As we mentioned earlier. So some of these calls may be premature, but the main point being you can use these forwards to look back through time and come and try and make an analysis on what's going to happen next.
And then finally.
Alison Irvine
And so sorry. So is that then kind of understanding the premium that the DMO are paying for kind of issuing at those longer tenors versus what they might potentially pay if they were to kind of shorten that duration and you're suggesting it's not much more of a premium than historically has ever been, is that?
Luke Parker
Yeah.
Yeah, exactly.
Exactly. Yeah, exactly. So if they're, if they're confident there's the demand there and they're not sort of pushing yields higher artificially themselves. So they'll look at the comparison to the US, for example, and make sure that the UK is not kind of unique in its having a high yields, then they may well make the decision that this is just the premium that we are happy to pay for longer, for longer issuance essentially.
Alison Irvine
Oh, shutting up the haters, basically.
Luke Parker
Yeah, exactly.
Alison Irvine
Yeah.
Luke Parker
The last the last example I mentioned two year, one year versus five year five year earlier.
So whenever you have a cutting cycle, this curve tends to steepen a lot, so the grey areas are when we've had the cutting cycles. This is in the US.
And the black line or the dark green line is the actual head funds rate. So as they've cut and the green line being two year, one year, five year, five year. So we've steepened up recently in this cutting cycle.
Although we have steepened up quite a bit compared to where we are in the cycle versus the historical moves, but then historically it has moved a lot steeper as rates have continued to be cut. So you know again you can use historical charts like this looking at interest rates and forward space to make market decisions and investments decisions on the back of that.
Alison Irvine
Thanks so much for sharing.
So I think we've kind of run through, I know the content that you've prepared in advance, which was absolutely which is really interesting. I think a topic that you hear a lot of lingo about and often I don't understand it. So this has been a great kind of run through of turning that lingo and jargon into kind of actual.
Kind of concepts that I can understand.
So thank you so much for running through that. Let's I can see that we have got.
One question in the chat. We've had a few subbed in in advance, so I think going back to your very first slide.
It'd be good to kind of talk a bit more about the how kind of the swap curve compares the guilt curves and when you might use one of them over the other kind of what, what would drive that.
Luke Parker
Sure. Yeah, that's a very good question. It's quite topical at the moment actually, so.
If you were issuing A5 year bond.
Often, particularly with yields where they are now.
Some clients wouldn't necessarily want to be paying fixed rates here, so so they would swap the issue.
And receive a receive rates via swap. The problem we have at the moment and why some clients don't want to do that even though they don't necessarily like paying this level of yields.
If you're receiving swaps, you're actually receiving a lower yield than where you've issued the bond because of the difference between these two curves. Now, in the past, the short end of this curve, the guilt yields have actually been lower than swaps, and then it's moved. So there are lines have crossed over basically around about halfway through. But now because of the amount of supply we've got coming from the.
The government guilt yields are actually higher, so that does provide a challenge we've looked at.
Things like bond locks, where you can do a clients can actually sort of.
Forward purchase a government bond in order to lock in their interest rates via bonds rather than by swaps.
But again, that's quite balance sheet intensive. So some people still prefer the derivative, but that's one example where swap spreads sort of come into play in the real world for our clients.
Alison Irvine
So that plus some kind of looking at the swap spread is generally or kind of hedging your rates risk using a swap generally kind of less balance sheet intensive than if you were to look to get that same exposure through kind of owning the bond almost.
Luke Parker
Yes, exactly, exactly. But, but if you don't like the yield differential between swaps and bonds it you know, it might be a better option for you.
Alison Irvine
Kind of change your approach, got you great. And then I'll quickly, we've got two more minutes left, so I'll go through one last question that we got in advance. Have you seen corporate behaviour change when it comes to last few years? I know you mentioned there that we'd looked at some bond locks, but kind of yeah, what, how has that kind of morphed versus you know early 2020 versus what we're seeing now?
Luke Parker
Yeah. I mean, I think clients have becoming much more particularly as rates are being more volatile and rates are higher and curves have got more shaped to them than they had, you know, five or ten years ago. Clients are much more sophisticated and proactive in in finding hedging strategies.
Around projects they have or around corporate instruments they might have. So I think that's probably the biggest change, just a lot more activity.
Some of it kind of opportunistic on levels coming through and some of it choosing parts of the curve that they've.
You know, within their own accounting methodologies are able to almost take a advantageous position if you like rather than just with their hedge from an issue or with their choice of where to issue rather than just, you know, issuing to raise the money and kind of moving on. It's probably the biggest difference.
Alison Irvine
So kind of, yeah, increasing awareness and that's driving increasing sophistication.
Luke Parker
Yes, absolutely.
Alison Irvine
Oh, interesting. Great. Thank you. Well, Luke, I think we'll leave it there. Thank you so much for taking your time to run us through this today.
We to kind of all attendees, we really want to hear your feedback kind of let us know what you liked and potentially other topics that you might be interesting interested in hearing about. So please do kind of e-mail in, let us know you can sign up to the mailing list so that you can get notification of all of these.
Luke Parker
Pleasure.
Alison Irvine
Sessions running forward and obviously we do also have all of the past sessions saved on.
The website, but other than that, thank you very much for dialling in and we will see you next time.
Luke Parker
Thanks everyone.
Alison Irvine
Thanks. Bye, bye.
