Expect changes in interest rate swaps

The IRS market is where investors can exchange a floating interest rate (usually re-setting every six months) for longer-term fixed rates. 

The five-year IRS rate moved up from below 3.2 per cent in late January to above 3.5 per cent on February 22. Similarly, the ten-year IRS rate moved up from below 3.5 per cent to above 3.9 per cent in that same time span. 

There has been a slight recovery since then, but the sharp movements reflect a couple of key factors. 

First of all, there is increasing sentiment that local interest rates will be moving up later this year. 

Markets are increasingly pricing in that the central bank will not be reducing its policy interest rate further, after 0.25 per cent cuts in each of its last two meetings. This is partly due to signals from the central bank that rates are already sufficiently accommodative for growth. 

It also reflects expectations that improving economic activity, and increased funding requirements (from both the public and private sectors) will put pressure on interest rates to rise later this year. 

These expectations have not yet been reflected in the bond market, which is more affected by immediate-term demand and supply considerations. But they are beginning to be seen in the IRS market – to hedge against possibly rising rates, investors and corporates want to pay longer-term fixed rates on interest rate swaps, leading to pressure for swap rates to increase. 

The second factor has been the Bank of Thailand’s proposals on imposing a new 0.47 per cent fee on bills of exchanges (BEs) issued by banks. 

One part of the market has been structured Bes. These are fixed-income instruments that combine a normal BE with an interest rate swap. These are mainly sold to institutional investors, to produce customised cash flows that better match those investors’ particular requirements. 

A new fee imposed on these BEs would hurt their investment viability to these very price-conscious investors. Some market players were worried that the fee would lead to a significant amount of swap transactions being cancelled and reversed. These fears led to a lot of pay-fixed interest in the local market, exacerbating the upward movement in IRS rates. 

Of these two factors, the first one, on interest rate expectations, appears to be a fundamental issue that will continue to affect the market over the next several months. It may also eventually affect local bond yields as well, as new government bond supply gets launched and the under-supply from the last quarter no longer becomes an overhang. 

The second factor, on BE regulations, appears to be more transient. There are already reports that some types of fixed-income instruments sold to institutional investors may be exempt from the regulations. As a result, the upward push to rates from this factor appears to be running out of steam. In any case, however, further developments on this issue bear monitoring going forward. 

 

Parson Singha is chief markets strategist, Global Markets Department, HSBC Thailand.