Photographer: Andrew Harrer/Bloomberg

Post-Crisis Phenomenon of Upside-Down Swap Spreads Fades Away

Updated on
  • 10-year swap rates are again eclipsing Treasury yields
  • Regulatory rollback, prospect of less company debt at work

One of the odder distortions created by post-crisis financial regulation -- the unprecedented decline in U.S. swap rates below Treasury yields -- may be poised to end.

Swap rates, what companies pay to exchange fixed interest payments for floating ones, are on track to rise back above Treasury yields across all maturities for the first time since 2014. The swap spread, as the gap between the two is known, turned negative in 2008 for the first time ever in the long end. It was the start of a shift that traders view as anomalous because it theoretically indicates that the market views the credit of banks as stronger than that of the U.S. government.

Now several forces are at work that are restoring the relationship to what it was in the decades before the financial crisis -- including the prospect that Republicans’ tax-overhaul plans could reduce corporate issuance, stemming the typical post-sale use of swaps. There’s also speculation that regulatory relief is ahead for banks, making it more attractive for them to hold Treasuries.

“No swap spreads of any maturity should be negative at this point,” said Richard Gilhooly, head of macro rates strategy at CIBC World Markets. “This is happening now. You are close to the capitulation for these spreads.”

Swap rates serve as a benchmark for a variety of debt purchased with borrowed funds, including mortgage-backed and auto-loan securities. So wider swap spreads can push relative borrowing costs higher for some entities.

The 10-year spread turned positive Monday and Tuesday, and logged its highest close since 2015 on Monday. It’s set to move to positive 10 this year, Gilhooly predicts. The 30-year, at about minus 20 basis points, may expand to positive 20 next year, he said. Last year, the 10-year sank to minus 19 basis points and the 30-year to about minus 60, both records in data going back more than two decades.

‘Perverted’ Phenomenon

Treasury yields moved above rates those on similar-maturity swaps (which are based on the London interbank offered rate and so have credit risk) in the wake of post-crisis regulation that boosted dealers’ cost of holding government debt. In 2009, Gerald W. Buetow, co-author with Frank J. Fabozzi of a go-to textbook for pricing swaps, called the phenomenon “perverted.”

Donald Trump’s election victory triggered much of the rebound in spreads in the past year. The president’s promises to ease the regulatory burden on Wall Street had analysts predicting that Treasuries were set to become more liquid and cheaper for banks to hold on their balance sheets.

Trump’s choice of Federal Reserve Governor Jerome Powell to replace Janet Yellen as chair is playing a part, too. Powell is seen as supporting deregulation, and his nomination factored into TD Securities strategists’ forecast for additional 30-year spread widening in their 2018 outlook.

Analysts are also monitoring the progress of tax-overhaul legislation, which could crimp corporations’ ability to deduct debt-interest costs from earnings and make it more attractive for companies to bring home overseas cash.

The net effect would be to spur widening by reducing demand for swaps, according to CIBC’s Gilhooly. Companies have been piling on debt to lock in historically low borrowing costs, and they frequently convert the issuance from fixed to floating payments, which causes swap spreads to tighten.

Changed Landscape

But even as analysts anticipate more widening, they see a changed landscape for the market that will limit the rebound.

The risk in swaps has diminished because of provisions of the Dodd-Frank Act under which over-the-counter derivatives such as swaps are now centrally cleared, removing counterparty credit risk. That means spreads won’t return to past peaks, said Moorad Choudhry, a professor in the business school at the University of Kent in the U.K., who’s written books on finance.

“These spreads shouldn’t be as high as they were 10 or 20 years ago, but they should be positive as Treasuries are completely risk-free,” he said. “This is a positive sign as it signals the economy overall is returning back to normal.”

To be sure, the widening trend could be limited if lawmakers fail to push through tax legislation or trim regulations, said Aaron Kohli, a strategist at BMO Capital Markets.

Yet he sees other forces at work that are supporting the move, in particular the Treasury’s move to stabilize the average maturity of the nation’s debt, after extending it in recent years.

Long-end spreads will tend to widen because of “the fact that the Treasury Department focused most of their supply increases for now in the front end,” he said. “At the end of the day, the swap spread is all about the relative supply and demand of Treasuries.”

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