Hedges blow up after risk gauges in Germany’s government debt market exceeded those of the 2008 world crash.
Guest Post by David P. Goldman from AsiaTimes.com:
NEW YORK – Risk gauges in Germany’s government debt market rose last week to levels higher than recorded in the 2008 world financial crash, as margin calls forced the liquidation of derivatives positions held by banks, insurers and pension funds.
Big institutional investors that spent the past ten years insuring their portfolios against falling interest rates now face massive losses as hedges blow up. A key measure of market risk, the spread between German government bonds (Bunds) and interest rate swap agreements jumped above the previous record set in 2008.
The cost of hedging German government debt with interest-rate options, or option-implied volatility, meanwhile rose to the highest level on record.
The blowout in the euro derivatives market follows a near-collapse of the British government debt, or gilts, market, averted at the last minute by a 50 billion pound bond-buying spree by the Bank of England.
The world’s central banks responded to the 2008 world financial crash and the European financial crisis of 2011 by pushing bond yields down.
“Real” yields, namely the yield on inflation-indexed government bonds, went deeply into negative numbers in Germany and the UK, followed by the US market. That pulled the rug from under insurance companies and pension funds, which invest pension payments and insurance premiums to provide for future income.
To compensate, European and UK institutions locked in long interest rates with derivative contracts, or interest-rate swaps, that receive a long-term interest rate while paying a short-term interest rate. Swaps are a leveraged position that requires collateral worth a fraction of the notional amount of the contract.
When the Fed jacked up interest rates in late 2021, the value of interest rate swaps that pay fixed and receive floating imploded. Pension funds and insurers were stuck with the equivalent of a ten-to-one margin position in long government bonds. The price of long government bonds fell by nearly 20% across the Group of Seven countries, and the value of derivatives contracts evaporated.
Guest Post by David P. Goldman from AsiaTimes.com.
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