One of the odder distortions created by post-crisis financialregulation—the unprecedented decline in U.S. swap rates belowTreasury yields—may be poised to end.

Swap rates, what companies pay to exchange fixed interestpayments for floating ones, are on track to rise back aboveTreasury yields across all maturities for the first time since2014. The swap spread, as the gap between the two is known, turnednegative in 2008 at the long end for the first time ever. It wasthe start of a shift that traders view as anomalous because ittheoretically indicates that the market views the credit of banksas stronger than that of the U.S. government.

Now several forces are at work that are restoring therelationship to what it was in the decades before the financialcrisis—including the prospect that Republicans' tax overhaul planscould reduce corporate issuance, stemming the typical post-sale useof swaps. There's also speculation that regulatory relief is aheadfor banks, making it more attractive for them to holdTreasuries.

“No swap spreads of any maturity should be negative at thispoint,” said Richard Gilhooly, head of macro rates strategy atCIBC World Markets. “This is happening now. You are close to thecapitulation for these spreads.”

Swap rates serve as a benchmark for a variety of debt purchasedwith borrowed funds, including mortgage-backed and auto-loansecurities. So wider swap spreads can push relative borrowing costshigher for some entities.

The 10-year spread turned positive Monday and Tuesday, andlogged its highest close since 2015 on Monday. It's set to move topositive 10 this year, Gilhooly predicts. The 30-year, at aboutminus 20 basis points, may expand to positive 20 next year, hesaid. Last year, the 10-year sank to minus 19 basis points and the30-year to about minus 60, both records in data going back morethan two decades.

'Perverted' Phenomenon

Treasury yields moved above rates those on similar-maturityswaps (which are based on the London interbank offered rate and sohave credit risk) in the wake of post-crisis regulation thatboosted dealers' cost of holding government debt. In 2009, GeraldW. Buetow, co-author with Frank J. Fabozzi of a go-to textbookfor pricing swaps, called the phenomenon “perverted.”

Donald Trump's election victory triggered much of the rebound inspreads in the past year. The president's promises to ease theregulatory burden on Wall Street had analysts predicting thatTreasuries were set to become more liquid and cheaper for banks tohold on their balance sheets.

Trump's choice of Federal Reserve Governor Jerome Powell toreplace Janet Yellen as chair is playing a part, too. Powell isseen as supporting deregulation, and his nomination factored intoTD Securities strategists' forecast for additional 30-year spreadwidening in their 2018 outlook.

Analysts are also monitoring the progress of tax overhaullegislation, which could crimp corporations' ability to deductdebt-interest costs from earnings and make it more attractive forcompanies to bring home overseas cash.

The net effect would be to spur widening by reducing demand forswaps, according to CIBC's Gilhooly. Companies have been piling ondebt to lock in historically low borrowing costs, and theyfrequently convert the issuance from fixed to floating payments,which causes swap spreads to tighten.

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Changed Landscape

But even as analysts anticipate more widening, they see achanged landscape for the market that will limit the rebound.

The risk in swaps has diminished because of provisions of theDodd-Frank Act under which over-the-counter derivatives such asswaps are now centrally cleared, removing counterparty credit risk.That means spreads won't return to past peaks, said MooradChoudhry, a professor in the business school at the University ofKent in the U.K., who's written books on finance.

“These spreads shouldn't be as high as they were 10 or 20 yearsago, but they should be positive as Treasuries are completelyrisk-free,” he said. “This is a positive sign as it signals theeconomy overall is returning back to normal.”

To be sure, the widening trend could be limited if lawmakersfail to push through tax legislation or trim regulations, saidAaron Kohli, a strategist at BMO Capital Markets.

Yet he sees other forces at work that are supporting the move,in particular the Treasury's move to stabilize the average maturityof the nation's debt, after extending it in recent years.

Long-end spreads will tend to widen because of “the fact thatthe Treasury Department focused most of their supply increases fornow in the front end,” he said. “At the end of the day, the swapspread is all about the relative supply and demand ofTreasuries.”

From: Bloomberg News

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