Could big banks be safer than the U.S. government?
In an unusual twist, the multitrillion-dollar interest-rate swaps market, which investors often turn to for protection against swings in Treasury yields, is sending just such a signal.
That obviously can’t be right, so the more likely explanation is that an important market is malfunctioning. And it’s more than just a curiosity. Investors are facing greater exposure to new risks and less insulation from fluctuations in Treasuries, just as the Federal Reserve prepares to inject more volatility into the market.
The problem is that the derivatives aren’t tracking the U.S. government rates as reliably as they once did. When the market is functioning normally, investors essentially pay banks a fee to compensate them in the case of rising benchmark rates. The implied yield on the derivative would normally be higher than on comparable cash bonds because investors are taking on an additional risk of a big bank counterparty going belly up.
But that has reversed and the swaps have effectively been yielding less than the actual bonds for contracts of five years and longer, and this month the swap rate plunged to the lowest ever compared with Treasury yields.
Again, that’s only logical if investors think that big Wall Street banks are more creditworthy than the U.S. government.
There are a host of likely reasons for this phenomenon. The main one is it has become cheaper from a regulatory standpoint for big banks to bet on Treasuries by selling protection against rising yields than just owning the cash bonds. Analysts don’t expect this relationship to revert to its historical state anytime soon because the rules aren’t going away, and the effect of this is significant.
Corporate-bond investors who want to eliminate their risk tied to changing Treasury rates may not be able to hedge as well as they think through interest-rate swaps. In fact, at times, their derivatives contracts may become more liability than protection, as they were at times in the past few months.
“Fixed-income investors should care because their most popular hedging tool isn’t working as well,” said Priya Misra, head of global interest-rate strategy in New York at TD Securities. And it’s kind of bad timing: the Fed is preparing to depart from its zero-rate policy for the first time in almost a decade by raising benchmark borrowing costs as soon as next month.
This isn’t the first derivatives market to meaningfully depart from the underlying securities they seek to track. Wall Street banks are trying to make the single-name credit-default swaps market more liquid and a better reflection of perceived corporate risk at any given time. Share prices of debt exchange-traded funds have occasionally moved away from the value of the underlying index.
But in the $13 trillion Treasuries market, the deepest debt market in the world, which sets rates on mortgages to auto loans, even a small divergence can have a big consequence.
In this case, an important hedge may be weakening just when investors need it the most.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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