Wednesday, March 24, 2010

Swap spreads collapse

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?


John said...

If institutional investors are more willing to hold AA bank credits than treasuries then what does that mean for bank equities? It appears that AA bank bonds are increasing in price if the swaps are collapsing. Do the bank stocks follow their bond prices? It would seem logical to me they would. If I am inferring too much here let me know. Thanks.

Benjamin Cole said...

Interesting speculation--although, the bond market may be speaking to a hugely expensive ($1 trillion and counting) and ongoing wars in Iraqistan, and other enbedded and ossified and relentlessly increasing global military costs. After all, a deficit dollar is a deficit dollar--if spent on a rural dell or an urban hell, propping up a foreign narco-state or a welfare queen with diabetes and a huge bag of Dorito chips in Alabama.
I agree with your general view--the bond market knows that our two major parties cannot balance the federal budget.
Meanwhile, America's large corporations are cash-rich (see LA Times today).
(If you think there is a shred of hope the R-Party can cut the deficit, I refer you to 2000-2006, in a better econmoy than we have now.)
It is a terrible situation.
Maybe Ron Paul can win the 2012 R-Party nomination. I hope so. But I think it will be Sarah Palin.

John said...

Ben you are right on with neither party being able to reign in the deficit. They are both guilty. I'll leave the matter of which is more guilty to another discussion. Somehow however, I can't swallow the idea that the 'swap drop' in the fault of military spending. It likely has more to do with despairing over the fact that there is no light at the end of the deficit tunnel. I have long held the opinion that it will require a crisis to solve this problem. Our representatives are not elected to slash spending. They are elected to distribute government money to their constituents. My feeling has been that this crisis is a little like dying: we're gonna, but not yet - and maybe not for a long time. Well, maybe the 'swap drop' is signaling that crisis may be getting nearer.

Scott Grannis said...

John: swap spreads are "traditionally" a proxy for AA bank credit risk, but only in a generic sense and I'm not sure that is completely applicable to today's market. Think of swap spreads as a highly liquid measure of generic AA risk. In any event, I note that bank stocks are up over 16% in the past six weeks, and I assume that the price of bank debt has also increased of late.

Benjamin Cole said...

I agree that Obama's national health plan, and our endlessly uncunning federal government, is a reciope for even larger deficits.
Still, look at the numbers.
In the next 10 years, we will spend roughly $10 trillion on our global military. It has to be financed somehow. It dwarfs Obama's new health care program.

Troe, we notice the straw that breaks the camel's back, the home run that "wins" the game (and we forget the excellent defensive play that saved two runs in the third inning).

But the reality is there is a lot of weight underneath this last straw.

I do not condone adding the straw, but I would also like some serious, gimlet-eyed review of all federal spending.

My own view is that every public agency has to endure a 50 percent budget whack every 20 years. There is no market competition.

A restaurant that doubles in
staff without more output gets run out of business.

Not so for HUD, USDA, the Los Angeles Police Department or the Department of Defense.

Paul said...

Obamacare is hardly a "straw."
It's more like America is drowning in red ink and the guy you voted for just threw us an anvil.

Perfectly predictable to anyone who was paying attention.

randy said...
This comment has been removed by the author.
Public Library said...

Most global governments are playing the same hand. The lets see if we can get out of debt by issuing more debt game.

While this may work for some, and is surely more doable during normal times, if everyone tries to unload at the same time, something has to give. Just like the panic of 2008.

We should not be surprised to see a sovereign debt crisis in our future.

Rob said...

I don't understand why, then, the $ has been geting stronger recently agaonst other major currencies ...

Scott Grannis said...

Rob: I don't pretend to understand how everything fits together either. We're in interesting times right now.

Scott Grannis said...

Public: bear in mind, of course, that sovereign debtors that also control their own currency can print money to pay their obligations.

Steve Fulton said...

You all are overthinking it. A treasury bond or any other bond carries principle risk a swap doesn't. It's off balance sheet duration with no principal at risk. Perfect for when banks are reducing leverage from 33X to 12X.

Scott Grannis said...

Steve: can you explain this a little more? The fact that swap spreads are falling significantly is a sign that more people want to add duration to their portfolios via swaps than want to subtract duration via swaps; and/or that people want to add swap duration and subtract Treasury duration. How does that fit with banks wanting to reduce leverage?

Public Library said...


I agree countries who can print are in 'better' shape but as you've always stated (and I agree), a weak currency is not something to cheer about.

There are always consequences. Especially with the severity of the comprises necessary to right the ship.

Personally, I believe America still lives in a fantasy land where people believe governments job is to make sure we never pay for our decisions.

The government can only hold up this fallacy for so long. We are getting nearer then end of the road every day we don't make serious change.

This is one reason you continue to see the size of government balloon.