Eurodollar interest rate swap market experiences drastic fluctuations, traders struggle to price in the impact of the Iran conflict.

The Iran war has cast a shadow over global inflation and economic growth prospects, affecting interest rate trends. This uncertainty has intensified volatility in the interest rate swap market, with traders betting on the next moves of major central banks. With the ongoing Middle East conflict, interest rate bets in the US and Europe are experiencing drastic and unpredictable fluctuations. The interest rate swap market is closely watched as an important indicator of interest rate expectations. Price movements in the interest rate swap market reflect dramatic changes in expectations. Previously, investors expected the Bank of England to cut interest rates twice this year (by 25 basis points each time), but now they expect there may be four rate hikes. However, trading activity in the interest rate swap market is much more complex, as traders are not only making directional bets; some traders also hedge against fluctuations in borrowing costs. The volatility in the interest rate swap market also has broader implications. Its fluctuations can affect various asset classes, including stocks and bonds, and even impact mortgage rates and government budgets. What is the interest rate swap market? Traders have been trying to predict central bank interest rate movements. One of the main methods of tracking these expectations is through interest rate swaps linked to risk-free overnight borrowing rates - these benchmark rates represent the cost of interbank overnight borrowing and move in sync with central bank policy rates. These swap transactions are linked to central bank policy decision dates and involve both parties exchanging interest payment flows over a specific period. If investors bet on a central bank rate hike, they agree to pay a fixed rate, while receiving a floating rate that fluctuates with daily borrowing rates. If they choose to receive a fixed rate while paying a floating rate, they are betting on a central bank rate cut. As traders build these positions, the fixed rate is adjusted until supply and demand are balanced - in other words, buyers and sellers reach a consensus on the level of central bank rates for a specific period. However, this does not mean that this consensus should be considered a benchmark. Pricing in the swap market often cannot accurately reflect the scale and speed of actual interest rate changes. For example, based on the UK's response to the pandemic measures, it is clear that traders failed to accurately judge how many rate hikes would be needed to curb inflation, and then overestimated their expectations once rates stabilized. Who uses the swap market? Banks, asset management companies, hedge funds, and corporations all use the swap market, either to hedge central bank policy risks or to mitigate risks from future interest rate fluctuations. For example, if a company holds a floating rate loan, its interest payments will increase as central bank rates rise. To hedge this risk, the company can enter into a separate interest rate swap contract (usually with a bank), paying a fixed borrowing cost but receiving a floating rate in return. Similarly, investors with a large amount of bonds may want to hedge against the risk of rising central bank rates, as rate hikes can cause bond prices to fall. Signing a swap contract to receive a floating rate allows them to profit when rates rise, offsetting price losses in the bond portfolio. Hedge funds typically have much shorter investment horizons than corporations using swaps for hedging purposes. Therefore, these funds may take advantage of the volatility in the swap market to bet on the speed and extent of interest rate changes. Why have interest rate bets in the US, UK, and Eurozone been so volatile recently? Since the outbreak of the Iran war, some markets expected interest rates to be significantly lowered, while others expected rates to be raised multiple times. The main driver is that the conflict has disrupted the supply of Middle Eastern energy and other commodities, pushing up prices, and prompting central banks to take measures to curb inflation, causing market uncertainty. At the same time, some investors have started to worry about whether this crisis will ultimately lead to a slowdown in economic growth and force major central banks to lower rates. The interest rate repricing in the Eurozone and the UK has been the most dramatic, as these two economies heavily rely on energy imports and are more susceptible to large fluctuations in oil and gas prices. The European Central Bank and the Bank of England's main responsibility is to maintain price stability, while the Federal Reserve has a dual mandate to promote price stability and full employment. The volatility of interest rate bets tends to be exacerbated by traders' incorrect direction bets, forcing them to close positions, often resulting in losses. Why is the swap market so important? Fluctuations in interest rate expectations affect all types of assets, as interest rates are the foundation of almost all asset valuations. For stocks, valuation is typically based on the present value of expected future cash flows, with interest rates serving as discount factors; if the market expects rate hikes, the present value of these future cash flows will decrease. Interest rate expectations also affect the real economy. If the market expects a central bank rate hike, investors will demand higher bond yields to attract them to sell cash, thereby increasing government borrowing and refinancing costs. This usually leads to increased budget deficits and may prompt the government to cut public service expenditures. In some countries, interest rate swaps also affect the real estate market. In the UK, fixed-rate mortgages usually keep rates stable for two to five years, and swap transactions help determine the rates offered by banks. Market fluctuations make loan pricing difficult. Since the start of the Iran war, swap rates have soared, causing many lenders to withdraw products from the UK market, reducing options for homebuyers. The operation of mortgages in the US is different, as standard 30-year mortgage rates are not linked to swap rates, but are closely related to the yield on the 10-year US Treasury bonds. In general, the volatility in the swap market makes planning for households, businesses, and governments more challenging. However, central banks can benefit from this. If the swap market pricing is efficient, its impact on the real economy can play a role in central bank actions, such as tightening or loosening monetary policy, reducing the need for policy actions by central banks.