Tuesday, February 24, 2009

Good news recap (5)

Swap spreads have declined significantly. To be sure, they are still higher than would be considered "normal," but they are now back to levels that preceded the current equity disaster. If anything, lower swap spreads are a sign that the fixed-income market has recovered a good measure of the liquidity it had lost at the height of the panic back in October and November. Lower swap spreads also signify an improvement in people's willingness to accept counterparty risk, and that is in turn a key sign of rising confidence.

I've been disappointed that equities haven't rallied in the wake of the improvement in swap spreads, but I've noted before that while swap spreads have been excellent leading indicators of conditions in other markets, that lags can at times be significant. For example, swap spreads started declining just before the onset of the 2001 recession, and credit spreads didn't start declining until late 2002. So I'm willing to be patient.


David said...

Hi Scott,

What does the 2-year swap spread represent? Why is it so meaninful?



Scott Grannis said...

Swaps are agreements between two parties to exchange cash flows. In a typical swap, A pays a fixed rate of interest to B, and B pays a floating rate (Libor) to A. A also needs to pay B a spread above the fixed rate to compensate him for the increased risk he takes on.

Swap spreads are thus an indicator of how willing people are to transact with each other, how much it costs to reduce your risk, and how liquid the market is. Swap spreads can also be thought of as representing the riskiness of a generic AA rated bank--the higher the spread the more risky banks are preceived to be.

The swaps market is huge but generally restricted to large institutional investors and broker-dealers.