Delano spoke with Julien Pénasse, associate professor of finance at the University of Luxembourg,  and to understand the reasons behind the continued surge in overnight index swap volumes in the euro area, contracts that are specifically designed to hedge against or speculate on changes in overnight interest rates.

In addition to his work at the University of Luxembourg, Pénasse has been a research associate at the Institut Louis Bachelier in Paris since 2012, actively engaged in applied research on investigating return predictability and its consequential impact on asset allocation strategies.

Kangkan Halder: What do you consider to be the reasons behind the increase in the OIS market volume?

Julien Pénasse: The most probable explanation is that banks are seeking to cover interest rate risk more with the rise in rates. As you know, banks typically have high-duration assets and low-duration liabilities.

Therefore, they tend to be subject to interest rate risk when the rate rises--the value of their long-term, often fixed-rate assets decreases while they must finance themselves short-term at a higher cost.

In theory, banks are supposed to cover most of their interest rate risk, but this is not always the case, as the recent failure of SVB [Silicon Valley Bank] has shown.

What could be the potential implications, such as credit risk, banking and monetary policy transmission, among others?

It’s hard to say without knowing exactly the banks’ positions.

Covering interest rate risk is perfectly normal and at first glance, this increased need for coverage may simply reflect the greater uncertainty currently prevailing. This could be simply seen as a normalisation, the period of zero or even negative rates being perceived as an exception to the rules over the past 30 years.

However, we must not exclude the possibility that some banks are fragile and thus are seeking to catch up on their hedges. Even though there has been an effort to strengthen banks’ solvency since the 2008 crisis, regulatory failure in Europe can never be ruled out.

After all, that’s what happened recently in the United States with SVB.

As markets anticipate at least one, if not two, more rate hikes from the European Central Bank, how would it affect the OIS markets? Would it maintain the segment at the same levels or lead to further increases?

It’s more about increased uncertainty than having certain rate changes. As I mentioned above, it is not unusual to expect rate changes over time.

Generally, the greatest source of uncertainty corresponds to changes in monetary policy stance, so indeed, the markets will likely try to anticipate an inflection in the ECB’s policy direction.

When the uncertainty has diminished, for example when the markets have agreed on the inflection point, we may see a reduction in volumes, even if rates are then expected to remain stable or decrease.

What do you expect in the coming quarters, generally speaking?

Everything will depend on the inflation dynamics in Europe.

Recent signals point to a slowdown in inflation, but I don’t think the markets are betting on a normalisation with short-term rates as low as before.

I think a median scenario in which we extrapolate what has happened in the past months is a normalisation of rates at a slightly lower level.

In the medium term, given the current geopolitical risks, the need to change our production techniques to face climate change, and the inherent dynamics of inflation to persist, there is little chance that we will find inflation rates as low as in the past, which were probably fueled by the growth of international trade. Of course, this is a median scenario.

There is a lot of uncertainty.

At the current moment, we are technically in a recession.

So this median scenario depends on the ECB’s reaction to production data as well as the economy’s reaction to the rise in rates in the following months.

I think we need to be humble because the effects of monetary policy, especially unconventional ones, are still not fully understood. And as I mentioned above, there is a lot of geopolitical uncertainty, which can affect commodity prices and also trade relations, especially between the United States, China and Europe.