Wednesday, March 24, 2010
I never thought I would see what this chart is showing. 10-year swap spreads have suddenly, for the first time ever, dropped below zero. They are now -7.25 basis points. Since swap spreads are traditionally a proxy for AA bank credit risk, this means that the market prefers to own 10-yr AA bank debt rather than 10-yr Treasuries. (For my short primer on swap spreads, see here.)
I've several explanations for the recent plunge in swap spreads, but not one that is compelling. The latest one is that corporations are rushing to issue lots of fixed rate debt and then swapping it back to floating; that is equivalent to a surge in demand to receive fixed in a swap transaction, which is itself equivalent to a surge in demand for long-term corporate bonds. But no matter what, the fact that swap yields are lower than Treasury yields can only mean one thing: Treasury bonds are no longer considered to be the most default-free instruments on earth.
Why this should suddenly be the case, however, I don't know. Sure, the healthcare bill will swell the deficit by a huge amount. But we've known for a long time that the federal deficit was going to be gargantuan, and federal unfunded liabilities are ginormous.
I suspect that the imminent end of the Fed's plan to purchase $1.25 trillion of MBS may have something to do with this, but I'm not sure.
But no matter what, the message here is that the market has taken a sudden dislike to Treasuries. And to put it in context, swap spreads have been declining for more than a year. The first phase of this decline was virtuous, since it reflected a return to health for financial markets, which in turn foreshadowed a recovery. But the latest part of the decline has become troubling, since it reflects a loss of confidence in the creditworthiness of the U.S.
Could this be the bond market vigilantes' way of dissing the passage of Obamacare?
Posted by Scott Grannis at 9:58 AM