23 March 2010

Interest Rate Swap Spreads on Treasuries Turn Negative for the First Time

Does this imply that the comparable LIBOR is lower than US Treasuries? If so, yikes (I think).

Purely technical, the result of govenment mandates for insurance companies and pension funds to match duration obligations, and some slightly more exotic hedging from the denizens of the trading desks?

Some also speculate that this is one or two primary dealers leveraging their interest rate derivatives. And that they are anticipating some fresh antics from Zimbabwe Ben.

I am fresh out of speculation on this, so if anyone has a cogent insight on this, I would not mind hearing it. You know how to reach me by email.

It does looks like the mispricing of risk. And as we all know, that can leave a mark. It might not be so bad if this is just a temporary thing, but I get the sense that the government's sworn commitment to subsidizing moral hazard is poking the market's animal spirits in the ass, and the risk trade is back on.

This seems to be a recurrent trend here in the Hogfather's School of Economic Mischief and Misery.

And in the meantime, Watch the Bond Market, not Bank Lending or Velocity.

Ten-Year Swap Spread Turns Negative on Renewed Demand for Risk

By Susanne Walker
March 23, 2010 12:45 EDT

March 23 (Bloomberg) -- The 10-year U.S. swap spread turned negative for the first time on record amid rising demand for higher-yielding assets such as corporate and emerging market securities.

The gap between the rate to exchange floating- for fixed- interest payments and comparable maturity Treasury yields for 10 years, known as the swap spread, narrowed to as low as negative 0.44 basis point, the lowest since at least 1988, when Bloomberg began collecting the data. The spread narrowed 3.38 basis points to negative 0.38 basis point at 12:40 p.m. in New York.

A negative swap spread means the Treasury yield is higher than the swap rate, which typically is greater given the floating payments are based on interest rates that contain credit risk, such as the London interbank offered rate, or Libor. The 30-year swap spread turned negative for the first time in August 2008, after the collapse of Lehman Brothers Holdings Inc. triggered a surge of hedging in swaps. The difference narrowed to negative 18.56 basis points today.

It’s hedge-related activity related to new corporate issuance,” said Christian Cooper, an interest-rate strategist at Royal Bank of Canada in New York, one of 18 primary dealers that trade with the Federal Reserve. “As more and more institutions receive, then swap rates will go lower.”

Interest Rate Hedging

Debt issued by financial firms is typically swapped from fixed-rate back into floating-rate payments, triggering receiving in swaps, which causes swap spreads to narrow. An increase in demand to pay fixed rates and receive floating forces swap spreads wider, provided Treasury yields are stable. Corporations that issue bonds also use the swaps market to hedge against changes in interest rates that may result in increased debt service costs.

The extra yield investors demand to own corporate bonds rather than government debt was unchanged yesterday at 154 basis points, or 1.54 percentage points, the narrowest since November 2007, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. High-yield debt returned a record 57.5 percent in 2009, and another 4.3 percent this year, according to the Bank of America index data.

“There’s a lot of money on the sidelines waiting for mortgage-backeds to cheapen up,” said Cooper. “In the absence of them getting cheaper and as the end of the buyback program comes near, people are looking for high quality spread products, so a good place to park is in swap spreads.”