Structural regulatory forces are pushing U.S. dollar swap spreads negative, breaking their historic relationship with the Libor spread to repo rates, Bloomberg strategist Tanvir Sandhu writes.

Swap spreads, the yield difference between receiving matched maturity fixed rates in the cash market and owning interest-rate swaps, have historically moved in tandem with the Libor/repo spread. To express a view that swap spreads will widen, investors buy Treasury bonds funded in the repo market, and receive three-month Libor on the swap leg.

The correlation has broken down in recent months. It could be restored by swap spreads returning to their historic levels above zero, or by repo rates climbing back above Libor. If repo rates were to rise above Libor, banks would demand a higher yield on their Treasury holdings.

Increased regulation and clearing structures that decrease derivative risk may keep spreads tight longer term. Meanwhile, the rally in the Libor/repo spread may have been driven by distorted repo rates, which have been affected by low liquidity and higher costs of repo financing for banks.

Price action

U.S. dollar swap spreads have widened recently, but they remain near all-time tights as funding cash positions remains unattractive compared with cleared interest-rate swaps.

Treasury 30-year bonds are currently approximately 50 basis points cheaper than their swap equivalents, while 10-year notes are approximately 14 basis points cheaper.

Seasonal drivers, Japanese demand impact

Seasonality shows swap spreads typically widen into the summer and tighten into year-end.

Into year-end, before bond issuance in the new year, dealers may choose to add swaps over Treasuries, as holding U.S. government debt requires balance sheet capacity. Meanwhile, seasonal investment-grade corporate bond issuance weighs on swap spreads, as companies bid to reduce debt costs by converting fixed cash streams to floating.

Recent yen appreciation has raised concern over potential Japanese demand for Treasuries, which may pressure yields lower and may drive shorter-maturity swap spreads wider.

Regulatory evolution, repo distortion

Central counterparties have eliminated the credit-risk premium historically embedded in swaps, making them a less risky vehicle and a less reliable measure of risk sentiment.

It has become more expensive for banks to offer repo financing, following leverage ratio limits and liquidity rules.

Low liquidity amid declining warehousing of risk by dealers, and selling pressure from foreign currency reserve managers may continue to exert upward pressure on repo rates relative to Libor.

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.

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