Swap spreads back to normal

This chart shows that we have reached an important milestone: 5-year swap spreads are now under 40 bps, a level that is fully consistent with what we might term "normal." Swap spreads first deviated from normal in early 2007 as credit market difficulties began to appear. Spreads shot up well in advance of last year's financial market crisis, thus establishing once again their value as a leading indicator of financial market and economic health. They then plunged in December, effectively forecasting the unwinding of the recessionary forces we have been witnessing in the past several months.

Skeptics will say that the decline in swap spread is all due to the Fed's massive liquidity injections, and thus represents an artificial and presumably temporary improvement. But I would counter with the observation that swap spreads represent real transactions between market participants, and the swap market is very large in size. Plus, we see confirming action in the decline of the VIX index (reflecting sharply lower fears on the part of investors), in the decline of credit spreads in general, and in the rise of equity prices in recent months. I would also note that the Fed's liquidity injections are nowhere near as large as the trillions that are bandied about. The vast majority of the increased reserves that the Fed has supplied to the system are still sitting in the Fed's accounts, unused. The main role the Fed has played so far has been to take some of the risky assets off the books of the banking system, and to supply reserves to facilitate the desire and the need of many institutions to deleverage.

As a result of the big drop in spreads we can now say that counterparty risk has declined materially; risk aversion has declined dramatically; systemic risk has declined significantly; and liquidity conditions in the bond market have improved substantially. These are all necessary conditions for a revival of confidence, and that is important because a lack of confidence was one of the key drivers of this crisis.

It is regretable that bond market volatility (as represented by the MOVE index) is still elevated. However, I think this is due primarily to the uncertainty that surrounds the Fed's program to purchase long Treasuries and mortgages in order to keep rates low. As I explained in a post yesterday, it is not at clear that the Fed can successfully implement such a program. The more bonds the Fed purchases, the higher the risk that debt monetization will lead to higher inflation and erode the value of all bonds.

So while the normalization of swap spreads is a significant milestone, all is not yet perfect. Monetary and fiscal policy leave a lot to be desired, and the real estate mess will take years to clean up. But at least there are clear signs of progress, undeniable green shoots.

(A short primer on swap spreads can be found here.)