Interest rate protection holders were selling out of positions in droves last week as Federal Reserve data released Wednesday were read as firmly backing the view rate rises are nearly over.
Players, including hedge funds and leveraged corporates, were looking to sell interest-rate caps as the value of these instruments tumbled. One New York trader said his desk has seen USD10 billion in sales of interest-rate caps since the Fed Chairman Ben Bernanke's testimony to Congress two weeks ago, compared with hardly any sales over the past few years. There was a major pickup in activity after the Fed released the Beige Book report on U.S. economic data. "Every bit of data just adds more confidence to these positions," said one New York trader.
The news boosted market expectations the Fed will pause rates when it next meets August 8. The Fed-funds futures August contract priced in a 42% chance of another quarter-point rate increase Wednesday, from a 53% chance earlier in the week.
There is now little demand for fixed-rate caps to hedge short-term rates, traders said, and people who own caps are selling or canceling them. Most of the activity is coming from speculative global macro hedge funds and leveraged corporate players, New York traders said. "If you're highly leveraged, every penny counts," said one. "Those people are going to take a more critical look at the current environment and try to save their premium."
Many of last week's sellers had bought three-month U.S. dollar LIBOR caps last year at 5-6%, when they were yielding around 3%, traders said. As DW went to press, three-month LIBOR was yielding 5.485%, and the most popular trades had 6-6.5% caps with one to two year maturities. Time decay on the earlier trades and the nearness of current yields to those strikes helped keep the price of interest rate caps static. "If you bought caps at low levels with strikes way out of money, you can get out now for something close to what you put in," said one trader.
