Beware of Greeks NOT Bearing Gifts…and Dogs That DO Bark in the Night
- By Karl Massey
- 2 min read
There have been some pretty extraordinary moves in short-term interest rates (STIR) over the last few days. They come as some policymakers finally start to catch up with the reality of inflation expectations, which began moving some time ago (Chart 1).
Oddly enough, the major moves were in AUD, NZD and GBP rates. The US STIR markets already price in about four hikes over next year – so more of a froggy in the simmering policy broth, at the moment.
I have not found these moves very surprising. But I have noticed something akin to that famous Sherlock Holmes ‘dog that didn’t bark’ observation. Funnily enough, the last time I recall this doggy noise not being heard was way back in 2007/8.
There is a rather forgotten Greek creature named Rho. Rho is the sensitivity of financial options to changes in the risk-free rate. At O’Connor, I was taught that an option is merely ‘a forward with an insurance policy attached’.
One might imagine that sharp multi-year daily moves in STIR should be reflected across pricings of all such derivatives in which the risk-free rate plays a role in valuation. (P.S., that is all of them!)
The funny thing is, yes and no. In interest rate options, yes. But as in 2007, as yet in FX options…no!
This is a puzzling concern – a quizzical heads up?!
However, another dog HAS barked. But nobody has owned up to hearing it yet.
In the credit markets, and specifically in the high-yielding and lower-quality credit markets, there is an utter fixation with credit spreads versus risk-free rates. I think that is fine – until a different benchmark becomes more relevant.
It has.
Quietly, without much fanfare, almost an entire cohort of high-yield bonds suddenly have a negative real yield (Chart 2). If the new benchmark is inflation, this is telling us all that in accepting the worst quality of credit risk, investors accept a losing real return.
In real terms, they are paying to accept default risk!
This has happened extremely rapidly. It seems to me that this is ‘a bit of a worry’. Heads up x100!!
Might this be the only chart you need?
Karl Massey has worked in financial markets since 1988. His experience incorporates fixed income and foreign exchange in Global Markets. His roles have included Head of Global Foreign Exchange at an asset manager , Head of Euro Liquidity at a UK bank, Portfolio Manager for several Alternative Asset managers. Most recently as Head of Market’s & Investment Director responsible for Fixed Income at a UK Pension Fund.