How the swaps market affects you
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Deputy Editor
Tim Bennett Dec 09, 2011
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Last week, markets cheered as the Federal Reserve used currency swaps to pump more money into the global economy. But what exactly did the Fed do? And how does the swaps market affect you?
The Fed to the rescue
Fears over the value of eurozone sovereign debt have left banks increasingly nervous about lending to their European peers. Fearing another credit crunch, the Fed last week made it easier for other central banks – and the European Central Bank (ECB) in particular – to borrow in US dollars. It did this by cutting a deal with the ECB to extend its dollar swap facility.
This means the Fed made it cheaper to borrow dollars using euros (and other currencies) as security for the loan (‘collateral’). The ECB can now put euros on deposit in New York, in exchange for dollars at an agreed exchange rate. The ECB has to pay interest charged at the Overnight Index Swap (OIS) rate plus 100 basis points (or 1%). That’s lower than the previous rate by 50 basis points (0.5%). When the dollars are swapped back into euros, again at a fixed rate, the dollar loan is, in effect, repaid. In the meantime, the ECB can lend dollars to any EU institutions that need them.
Why does it matter?
You might think this is all a technicality. But the swaps market has an impact on your own finances. Let’s say you’re looking for a mortgage. If you think rates will stay low, you’ll opt for a variable rate (the interest rate on this will be lower than on the equivalent fixed rate, because it is less risky for the lender). If you think rates are set to rise, you’d opt for the fixed rate. The choice is yours. But you only have this choice thanks to the swaps market.
For banks to be able to offer different mortgage products, they also need to be able to hedge their exposure to interest-rate moves. If you take out a fixed-rate mortgage, the bank will now receive a fixed income stream, in the form of your monthly payments.
Let’s say it thinks rates will rise. If so, the value of this income stream will diminish over time (because it’s fixed at a time when rates are rising). So to cover itself, it strikes a deal with another bank. It swaps the payments it gets from you for a floating income stream. That’s the basis of an interest-rate swap. Why did the second bank agree to the deal? Perhaps it is receiving an income stream from a variable rate mortgage it has written, and would rather be interest-rate neutral – so it switches its floating income for a fixed one.
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How does this affect you? The bad news is that the key Libor rate used across most sterling swaps has been creeping up, partly because of the market’s fears over the eurozone. As a result, in the last few days five major lenders have upped the rate they charge on new mortgage deals. So if it’s a short-term fix you want, bag a deal as soon as possible.
However, the good news is that, further into the future, markets still expect inflation and interest rates to remain extremely low. So if you are prepared to commit to a longer-term fixed-rate mortgage deal, they are available at record-low rates just now. For example, Leeds Building Society has just lopped 1% off its ten-year fix to bring the rate down to 4.99%.
A cheap way to play dividend growth
The swaps market is nearly impossible for retail investors to access directly. However, you can get close to a key part of it using an exchange-traded fund (ETF) that tracks the price of dividend swaps.
This allows a bank to swap its exposure to, say, BP’s dividend, for a fixed-income stream, often from another bank. The lower the fixed payment on offer, the lower the market expects BP’s dividend to be. This lets the bank hedge against unpleasant surprises, such as the dividend suddenly being slashed. But it won’t get the benefit if BP’s dividend rises – that will go to the bank on the other side of the swap.
Watching dividend swaps can give you an idea of what the market thinks will happen to dividends in the future – the higher the rate, the higher dividends are expected to be, and vice versa. Just now, for example, the dividend swaps market (based on the S&P 500 swap) is indicating modest dividend growth ahead, suggesting that investors don’t think there will be a double-dip.
For a dividend play closer to home, try the Lyxor ETF Euro Stoxx 50 Dividends (LSE: DIV). It tracks the growth in dividends of 50 of Europe’s biggest firms, rather than the share prices. In short, it’s a bet that companies can keep growing their dividends, rather than that share prices will rise. Recent performance has been patchy (see chart), but as Patrick Armstrong of the IM Distinction Diversified Real Return Fund tells Citywire, the ETF now offers “cheap access to dividend growth”.
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