Interest rate markets turbulence

One of the features of an illiquid, crisis-hit market is that arbitrage relationships break down. Another is a dramatic rise in settlement risk as bonds, even the best bonds, become illiquid. We are seeing both at the moment:

• The usual relationship between forward Libors and spot is breaking down by as much as ten basis points. In Euros for instance the 3m Libor 3m forward given by the futures is significantly different from that given by the spot Libors. (Sorry, I can't find a link to this.)
  
• Alea reports on a massive increase in repo market fails. The raw data is here.

The FT reports that a fund has been caught in another IRD storm:

A $3bn London hedge fund lost more than a quarter of its value on Monday as it became the biggest victim of the unwinding of a popular Japanese government bond trade that hit many rivals this week.

Endeavour Capital, run by former Salomon Smith Barney fixed-income traders, told investors it fell 27 per cent as a highly leveraged bet on the spread between short- and long-dated JGBs was hit by contagion from the US financial crisis and domestic worries. [...]

Hedge funds scrambled to unwind the so-called “box trade” – betting that 20-year bond and swap spreads would widen as seven-year spreads narrowed – early on Monday when the market moved sharply against them.

Presumably then they were long 20 year swap spread and short seven year, under the assumption that sevens were wide compared with twenties. Reuters gives more detail:

On Tuesday the 20-year swap rate was quoted at 2.050 percent compared with a 20-year bond yield of 2.150 percent, meaning the swap rate is 10 basis points below the bond yield.

The spread had reached to near -20 basis points on Monday when hedge funds and players were scrambling to unwind positions in a market where it is increasingly difficult to get trades done due to the worsening credit crisis, especially in the United States.

By contrast, the five-year yen swap spread soared to a record peak near 40 basis points last week. That move has stemmed partly from the jump in yen LIBOR rates due to the money market squeeze in the United States and Europe.

(The emphasis is mine and I have removed the Reuters tickers.)

In thin markets with forced sellers it is worth bearing in mind the simple fact that if there are more sellers than buyers, prices go down. Usually moves follow arbitrage channels as there are enough prop players willing and able to exploit opportunities. But at the moment there is not enough risk capital to bring these arbs in. Until there is, the markets will remain disconnected.

Update. Paul Krugman sets out another aspect of this dislocation here, noting that plummeting 1m T bill rates have not resulted in a matching fall in FED funds. They have fallen, but bank's reluctance to lend to each other even via the FED has kept FED funds at a relatively high spread over 1m CMT.