Historically, many interest rate trading strategies have not acknowledged the cyclicality of rate phases, overlooking leading market indicators. With rate cuts across the globe, Citi explores new methods for capturing interest rate trends and formulating trading strategies.
Interest rates reflect the levels at which central banks will lend to other financial institutions. They effectively control the costs of borrowing, holding, or lending capital. Any investor holding bonds or cash in any currency has an inherent exposure to interest rates. Increasingly interest rates are also being treated as an asset class in their own right. Indeed, today interest rate swaps are traded both by hedgers seeking to reduce exposure to rate fluctuations, and speculators expecting a change in interest rates or the relationships between them.
Trading in a low-rate environment
Historically, interest rate trading strategies were formulated in an era of tightening monetary policy where rates were high and rising. As such, the ideas and models created often overlooked the cyclicality of interest rates: that they must rise to prevent inflation in a boom and fall to stimulate growth in a bust.
As recent economic problems have forced central banks to adjust their base rates to historical lows at an unprecedented tempo, many such older models have under-performed. This newfound volatility of interest rates makes them an interesting alternative asset class with good opportunities to generate returns. Trading strategies must be adapted to provide positive returns under a variety of interest rate cycles and environments. This requires a dynamic, responsive approach that can identify trends early.
Finding trends, finding trades
There are three principal viewpoints an investor can express when trading interest rates. First, the directional trade, which takes a view on the future of interest rates in any currency. Second, curve trades, which look to exploit the difference between long- and short-term swap rates. Finally, cross-market trades identify trends in the spreads between the swap rates of various currencies. An investor can profit from movements in each of these levels once they understand their key drivers.
Each of these levels will move as market sentiment and expectations of future interest rates change. The most profitable trading strategies will be those which can predict the interest rate outlook in advance. This is often best achieved by interpreting changes in certain leading market indicators such as macro-economic data, rates and swap spreads. Based on these predictors, a profitable trading strategy can be overlaid. For example, if indicators predict a rise in interest rates, an appropriate solution could be a fixed for floating interest rate swap where the investor pays fixed and receives floating.
Citi Global Interest Rates Strategy
Citi has developed a number of models designed to identify those indicators which have been robust and accurate in illuminating trends throughout interest rate cycles. The models then translate these indicators into appropriate trading positions which are reviewed and adjusted weekly.
Citi's Global Interest Rates Strategy (GIRS) then takes six such models and combines them together into a composite rates trading strategy. These span directional, curve and cross-market trade types and have a very low correlation with each other. This helps them generate positive returns regardless of monetary policy cycles.
Combining such a comprehensive rules-based approach with a frequent rebalancing system makes this trading strategy particularly dynamic and reactive to changing market conditions. Indeed, whilst other traditional approaches have under-performed in the sudden switch to a low-rate environment, GIRS has performed well. From its inception on 29 June 2007 to 30 January 2009, Citi's EUR GIRS Index posted a cumulative return of 31.41% and a Sharpe Ratio of 1.89.