Swap Spreads Widen on Bets Fed Will Spur Inflation, Bianco's Simons Says

The Federal Reserve’s decision to buy $600 billion more in Treasuries through June has helped boost demand to exchange floating-rate obligations for fixed- rates, leading to a widening of swap spreads on concern inflation will accelerate, according to Bianco Research LLC.

Treasury two-year note yields fell to a record low of 0.3118 percent on Nov. 4, the day after the Fed announced its decision to buy Treasuries and said “subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” The central bank has held borrowing costs at almost zero since December 2008 to help stimulate the economy.

The two-year swap spread, or the difference between the rate to exchange the payment streams and the Treasury yield, widened by 9.06 basis points, or 0.0906 percentage point, to 30.24 basis points at 3:15 p.m. in New York. It was the biggest advance on a closing basis since May 24.

“The risk-reward of waiting for a move down isn’t very good” with Treasury yields, said Howard Simons, an analyst at Bianco Research in Chicago. “If you’re not going to move to fixed-rates now, when are you going to do it? We’ve pushed interest rates down as far down as we can, and this might be a good time.”

Consumer prices excluding food and energy rose 0.7 percent for the year ended in October, matching the lowest rate of core inflation on record reached in 1961, according to the median forecast of 17 analysts in a Bloomberg News survey. The report from the Labor Department is due Nov. 17.

Break-Even Rate

The gap between 10-year yields for conventional Treasuries and securities indexed to the rate of inflation has widened to 2.18 percentage points, near the highest since May, from 1.51 percentage points Aug. 24, as investors speculated the central bank would adopt policies that will stimulate the economy. The gap between the two yields, known as the break-even inflation rate, represents the forecast of bond traders for the rate of inflation during the life of the debt.

“If the Fed’s moves work, shouldn’t it start to push upward pressure on interest rates?” Simons asked. “If you go out and bang a drum and say, ‘I’m trying to raise inflationary expectations,’ pretty soon people are going to take you at your word.”

The 10-year swap spread was unchanged at 15.25 basis points today, widening from minus 4.25 basis points on Sept. 7. The 10- year swap spread turned negative for the first time on March 23 on concern that record borrowing by the U.S. government would lead to waning demand for Treasury securities.

‘Moves Up Fast’

When the yield on the 10-year note “starts to lift off the bottom, nobody wants it,” Simons said. The yield moves up “pretty rapidly when they move because, all of a sudden, the bond guys decide they can’t be long duration, and they have to shorten in. There’s no other side of the trade, so it moves up fast.”

Duration is a measure of the sensitivity of bond prices to fluctuations in interest rates.

Two-year swap spreads spiked upward in April and May, rising to 52.25 basis points on May 24, from 15.06 basis points on April 20, on concern the credit quality of European banks was deteriorating.

Swap spreads have widened in Europe, but not as sharply, indicating bank credit risk concern is not the culprit, Simons said. “You don’t need the European situation” to justify wider spreads, he said.

The European two-year swap spread widened 3.77 basis points to 69.30 basis points today. The spread has increased by about 9 basis points this month.

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net

To contact the editor responsible for this story Dave Liedtka at dliedtka@bloomberg.net

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