View From City Road: The derivative did it

Evidence that derivatives such as futures and options can have dramatic and unpredictable effects on financial markets and the rest of the economy, as many have long suspected but exponents have consistently denied, is mounting daily.

The latest comes from the Federal Reserve Bank of New York, whose researchers have been exploring the reasons for the US bond market crash earlier this year. In a paper published today, the bank details surprising new findings that the derivatives tail did indeed wag the economic dog.

According to the Fed's economists there is strong anecdotal evidence that huge dealings by Wall Street traders in US Treasury futures to hedge portfolios of mortgage-backed securities such as Fannie Maes and Freddie Macs followed the Fed's 8 February increase in short-term interest rates.

The reason was somewhat complex - which is one reason the scale of the rise in long-term bond yields from February took everyone by surprise. Mortgage-backed securities are assets made up of bundles of home mortgages. An increase in short-term interest rates tends to postpone mortgage repayment and lengthen the maturity of the securitised asset.

The New York Fed has managed to confirm that holders of mortgage- backed securities hedged their positions by short-selling Treasury bond futures at matching maturities. The US mortgage-backed securities market is bigger than the market for Treasury bonds of similar maturities. The effect of the February rise in short- term interest rates was therefore to lead directly to very substantial leveraged sales of long bonds.

What this all means is that because of activity in the derivatives market, a comparatively small though admittedly highly symbolic shift in short- term interest rates forced an entirely unforeseen and very substantial rise in long-term rates.

Such a finding has dramatic policy implications for the US. The authors conclude that the relationship between changes in short-term and long-term rates may have changed fundamentally. If small changes in short-term rates can have such unpredictable effects on long-term rates, then policymakers, in the US at least, must think that much more carefully about their actions. By the same token, trading in these markets becomes a good deal more hazardous. So much for derivatives reducing risk and lubricating the economy.