Trichet rate shock to echo in markets for years

LONDON (Reuters) - As financial market bombshells go European Central Bank President Jean-Claude Trichet's shock warning of a July interest rate rise last week was as explosive as they come and could reverberate for years.

Traders in euro zone interest rate futures, government bond and interest rate swaps markets were completely blindsided and suddenly forced to ratchet up their expectations of interest rates across the entire fixed income spectrum.

Not only that but financial market traders and investors are building in a risk premium that the ECB will tighten policy more than the "small," presumably 25 basis point move, that Trichet hinted at last Thursday.

Households and businesses, already tightening their belts in the face of rising inflation, falling housing markets and slowing consumer spending, now face higher borrowing costs.

The implication for the economy was clear: the surge in short-dated yields and swap rates over long-term ones -- a so-called "inverted" curve -- showed that investors expect growth to grind to a halt, perhaps even toward recession.

The carnage unleashed in financial markets by Trichet as investors were forced to bail out of positions by the violent price swings was on a scale few had ever seen.

"It's new space for everyone in the euro zone ... (and) it might take a couple of years before the ramifications of what we've seen fully play out," said Meyrick Chapman, rates strategist at UBS.

"If your entire existence demands involvement in rate markets the most useful advice we can probably offer is to take an early summer break and make it a long one. A good plan may be to reappear at the end of September when some sanity may have begun to return to rate markets," he said.

NO SMOKE WITHOUT FIRE

The head of interest rate trading at a U.S. bank, with more than 20 years experience in the market, said he could barely remember volatility like it.

"Nothing surprises me any more. It's tough times," he said.

Like Chapman at UBS, he said the market ructions were exacerbated by some investors being caught out by the volatility and forced to bail out of complex hedging trades related to the shape and direction of swap and yield curves.

"There's smoke there. And where there's smoke there's fire," he said of market rumors that some funds have suffered big losses.

If they have it would hardly be surprising. Some of the market moves were staggering.

The two-year/10-year euro zone government bond yield curve flattened by almost 50 basis points between Trichet speaking on Thursday and early Monday.

The roughly 10 basis point premium of 10-year yields over two-year yields evaporated to -40 basis points, the deepest inversion of the yield curve since the euro was launched almost a decade ago.

The two-year/10-year euro zone swap curve got crushed even more. It flattened by 60 basis points in that time to an inversion of almost 80 basis points, also a euro record.

And one-year swaptions volatilities, complex derivatives that measure the volatility on an option to buy a one-year swap contract, were up to five times greater on Friday than the day after the terrorist attacks on New York and Washington on September 11, 2001, traders said.

"It's very volatile. Clearly the market is very fearful that the ECB is heading for a Volcker-type scenario, where it's obliged to hike very aggressively to calm inflation expectations," said Ciaran O'Hagan, senior rates strategist at Societe Generale.

In the early 1980s the Federal Reserve under the chairmanship of Paul Volcker raised interest rates aggressively to kill rampant oil-fuelled inflation. The U.S. central bank succeeded, but at the expense of a long and deep recession.

With oil nudging an eye-watering $140 a barrel this week, some consumer and producer price measures of inflation in Europe are at their highest in over 20 years and in financial markets, still hobbled by the near one year-old credit crisis, there are grounds for grave concern.