1. Basic Concept: Understanding an Interest Rate Swap
An interest rate swap involves a contractual arrangement where both parties agree to exchange cash flows, derived from interest calculations, over a specified period. Interest rate swaps, however, do not involve an exchange of the principal amount, which is referred to as the notional amount. One leg of the deal involves a fixed interest rate, while the counterpart leg deals with a variable interest rate. The floating leg rate is usually based on a floating rate benchmark such as LIBOR, SOFR, among others.
The notional cash amount being exchanged means that no principal amount offers offsetting value. Each party to the swap earns interest based on the difference between the variable amount he receives and the amount fixed on the other leg.
Over the life of the swap, fixed rate swaps represent the market's forecast of future floating rates as it incorporates all levels of credit, spread and term premiums.
2. Policy Tools of the Central Bank and Influence Over the Economic Climate of a Region
Central banks are able to influence the economy through the use of different policy tools such as:
- Setting policy (short) rates (i.e. overnight, and/or repo rates)
- Performing open market operations (i.e. buying/selling bonds)
- Engaging in and/or circumventing quantitative easing (QE) and quantitative tightening (QT)
- Providing forecast (forward guidance) of what they intend to do
- Bending the yield curve through yield curve control (YCC)
These actions influence short-term interest rates directly, while also influencing future interest rates, the term structure of interest rates, and the risk as well as the liquidity premium.
3. How Swaps Show Changes in Central Bank Policy
The impact of changes in central bank policies on the swaps market is as follows.
A. Immediate Impact—Short-End Swaps
Short maturities in swaps will quickly increase if the central bank is raising or expected to raise the policy rate. This is because the floating future expected payments will need to be covered in the fixed swaps. Likewise, if the central bank cuts rates or is expected to cut rates, fixed rates will decline.
B. Term Structure
Central bank policies also influence the structure of the swap curve. For instance, if the central bank is expected to keep rates low for long periods and engages in QE, particularly the purchasing of long duration bonds, long rates and thus long fixed swaps will, to an extent, also decline. This will result in a flattening of the curve. In contrast, if a central bank is expected to tighten their policy rates due to an inflation threat, long rates and thus fixed swaps will increase, resulting in a steeper curve. This is because inflation expectations will be reflected in the longer-end fixed swaps.
C. Swap spreads: indicator of market pressures
The swap spread entails the difference between the swap fixed rate and the government bond yield. Central bank policies will shape the supply and demand of government bonds, determine the funding costs, and the risk premium. Therefore, determining the spreads will help theorize whether the market is in a state of stress or easing. For example, a certain negative policy by central banks will exacerbate dealer funding costs and repo stresses, thus pushing swap spreads negative.
D. Forward Guidance and Expectations
As swaps incorporate the anticipation of future payments, the swap market will react in advance, not wait for the actual policy. For example, a central bank may declare ‘we will keep rates low for some time’ or ‘we will raise rates if inflation persists’ and the central bank's policy will alter. Swap fixed rates change with current policy but also with expected future policy.
4. Examples & Illustrative Scenarios
In the scenario of a central bank unexpectedly hiking its interest rates to control inflation, the short-maturity swap fixed rates immediately increase, while long maturities may increase or decrease based on the market's inflation and expected growth rates.
If a central bank hints at an extended period of low, accommodative policy, short swap fixed rates will drop, and long swap fixed rates will drop more if the term premium decreases, thus flattening the swap curve.
In this context, QE indicates that purchasing long-duration bonds causes the long-term yields to drop, which decreases the fixed-rate payments on long-term interest rate swaps, thereby resulting in a flattening of the curve, or even an inversion, when short rates are held at a high level.
As an illustration, the OIS rate in India went up after the Reserve Bank of India decided to pause rate hikes, which points to expectations of rates being held high for a long period.
In yet another example, the hike in swap rates occurred in the context of aggressive monetary policies at the global level.
For Risk Managers, Traders, and Investors, Why Does This Matter?
Hedging and financing costs: fixed rate swap arrangements, from expectations based on central bank policies, will have different added costs for corporations and banks entering into swaps.
Interest rate exposure depends on which side of the swap: paying fixed, a rising rate environment will be more advantageous; paying floating, it will be a falling rate environment.
Curve trades: A steepening or flattening for curve shifts, specifically in the swaps, is considered a proxy for changes in the policy environment.
Spread trades: structural swap spreads entail macro funding gaps or other bank-sought balance sheet inefficiencies.
Policy expectations: swap rate shifts signal a possible policy change, relative to central bank policy, before an announcement is made, providing a macro signal.
Incorporating Key Nuances and Risks
Swap rates comprise more than just a policy rate. Expectations plus term premiums, credit and funding risks, and even liquidity are also factored in. Therefore, the movement of swap rates is not synonymous with the movement of policy rates.
The impact of policy changes from the central bank may take some time, and the market may "price in" anticipated changes before and after a policy shift.
The different fixed maturity legs comprise different term premiums and therefore the very short end of the curve may shift rapidly, whereas longer maturities may adjust more slowly or move primarily in response to term premiums and inflation expectations.
Structural and regulatory changes are also important and can lead to abrupt changes. For example, after the Libor transition, changes to benchmarks caused structural changes to the underlying swap spreads.
Within local or currency-specific markets, unique factors, such as liquidity and capital flows, may influence policy.
In Summary
Interest rate swaps offer the most valuable and direct assessment of future interest rate expectations.
The direct policy actions of central banks such as changes to rates, guidance, and the carrying out of QE or QT influence the short end of the swap rates and impacts the overall term structure.
Policy, funding, and credit stress intertwined swap curves, matured fixed-rate and spread.
For current market practitioners, the time value of swap curves and structural shifts in spreads provide utility when positioning for trading, hedging and risk management relative to anticipated actions of central banks.
