Swap Spreads Have Fallen, and They Can't Get Up

Something strange is happening in the U.S. rate market.

Something curious is happening in an esoteric corner of the U.S. rate market.

Swap spreads—a proxy for credit spreads—have turned negative.

This is a relatively rare occurrence in the market given that swap spreads usually involve a premium over U.S. Treasuries. The premium is paid by investors striking interest rate swap deals, exchanging fixed-rates of interest for floating rates (Libor). Because such deals involve significant counterparty risk, typically exposure to a bank, swap spreads have historically been positive.

But that usual relationship has been turned on its head in recent weeks.

You can see the change in the charts below, from Michael Shaoul at Marketfield Asset Management:

Here, for instance, is the five-year swap spread:

Source; Marketfield Asset Management

And the seven-year:

Source; Marketfield Asset Management

And here's the 10-year, now at its lowest on record.

Source; Marketfield Asset Management

The moves are causing some consternation for traders, analysts, and investors who are struggling to figure out exactly what is causing the trend to lower swap spreads. There are some varying theories.

Much attention has focused on more limited balance sheets at dealer-banks in the wake of new regulation, extra sales of U.S. Treasury bills, hefty issuance of corporate bonds, the selling of U.S. government debt by emerging market central banks, and recent hedging activity by investors in mortgage-backed securities.

First up is Shaoul:

We typically monitor U.S. Treasury Swap Spreads as an indication of stress, with the widening of spreads often a reliable [gauge] of distress within the dealer market (this certainly proved the case in 2008). In recent sessions we have been watching a quite different phenomenon, namely an unprecedented degree of spread inversion that now stretches all the way from the four-year to the 30-year portion of the treasury curve. This really suggests that something quite unusual is taking place within the Treasury market, made all the more interesting by the fact that underlying yields have actually been relatively placid while the inversion has been gathering steam.

And here are analysts at Société Générale:

... With the debt ceiling now out of the way, the ramp up of bill issuance is likely to add renewed pressure on dealer balance sheets over the coming weeks. ... Corporate issuance is starting to ramp up in November, the last big month for issuance ahead of year end. The average issuance for the past three years is around $120 billion. The swapping of corporate issuance is likely to keep the pressure on swap spreads.

Meanwhile, analysts at BNP Paribas argued a month ago that negative swap spreads are here to stay:

The collapse in US swap spreads has caused considerable consternation in the US rates market, but it has shown little sign of abating. Nor should it, in our view. Indeed, we see good reason for negative swap spreads to become the ‘new normal.’ ... In our view, the drivers of negative swap spreads are primarily regulatory, which has frustrated fair-value models. Regulatory-driven hedging costs, balance sheet charges and supply and demand could easily make swap spreads negative along most of the US curve.

For now there appear to be few easy answers to this particular market conundrum.