Something very strange is happening in the world of fixed income.
Across developed markets, the conventional relationship between government debt—long considered the risk-free benchmark—and other assets has been turned upside-down.
Nowhere is that more evident than in the United States, where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks. But these days, it’s just the opposite as a growing number of Treasuries yield more than interest-rate swaps. The same phenomenon has emerged in the United Kingdom, while the “swap spread,” as it’s known among bond-market types, has shrunk to the smallest on record in Australia.
Part of it simply has to do with the fact that investors are pushing up yields on Treasuries—which guide rates for just about everything—as the Federal Reserve prepares to raise borrowing costs for the first time in a decade. But in many ways, it reflects the unintended consequences of post-crisis rules designed to make the financial system stronger. Those changes have made it cheaper and safer to use derivatives to hedge risk, and more onerous and expensive for bond dealers to make markets in the safest securities.
“These kinds of dislocations can be expected to grow over time,” said Aaron Kohli, a fixed-income strategist at Bank of Montreal, one of 22 primary dealers that trade directly with the Fed. “The market structure and regulatory structure has evolved in a period with very low volatility. Once you take that away, it’s not clear what the secondary implications of that will be.”
It’s hard to overstate how illogical it is when swap spreads are inverted. That’s because it suggests that governments are less creditworthy than the very financial institutions they bailed out during the credit crisis just seven years ago. And as the Fed prepares to end its near-zero rate policy, those distortions are coming to the fore.
The rate on 30-year swaps, which allow investors, companies, and traders to exchange fixed interest rates for those that fluctuate with the market, and vice versa, has been lower then comparable yields on Treasuries for years now as pension funds and insurers increasingly hedged their long-term liabilities.
But in the past three months, spreads on shorter-dated contracts have also quickly turned negative. Now, five-year swap rates are about 0.05 percentage points lower than similar-maturity Treasuries, while those due in three years are also on the verge of flipping.
As the phenomenon becomes more widespread, it adds to evidence that it’s not just a one-off, according to Priya Misra, the New York-based head of global interest-rate strategy at TD Securities, another primary dealer.
“Everybody in the fixed-income market should care about this,” she said.
In the U.K., where the Bank of England is also debating whether to raise rates, the swap spread reached minus 0.05 percentage points on Nov. 12, the least since December 2013. The difference between 10-year Australian notes and comparable swaps fell to a record last week as speculation diminished the central bank will cut borrowing costs.
“Traditional pricing and relative-value rules are breaking down,” said David Goodman, head of global capital markets strategy at Westpac Banking Corp.
In a recent report titled the “Global Regulatory Crisis,” Goodman pointed to regulators’ efforts to head off another crisis as one of the reasons for the shrinking spreads.
One of those rules has moved swaps to central clearinghouses, which has pushed down costs by eliminating most of the counterparty risks of trading directly with banks. Another has been the so-called supplementary leverage ratio, an addendum from U.S. regulators to global capital regulations known as Basel III. In one part of the provisions, government bonds are considered just as risky as corporate debt.
That’s made banks less willing to own sovereigns and pushed them toward swaps, which eat up less cash and aren’t subject to the same capital requirements. U.S. commercial banks cut their Treasury holdings for the first time in two years in the three months ended September, even as their total government debt positions, including those backed by federal agencies, have continued to rise, Fed data show.
“We saw a lot of this accentuated at the end of September,” said Yvette Klevan, a fixed-income manager at Lazard Asset Management, which oversees $165 billion. “They wanted to clean up their balance sheets by reducing bond inventory.”
With China poised to cull its U.S. debt holdings for the first time since 2001, the decline in demand is contributing to higher borrowing costs. Yields on 10-year Treasuries have climbed from a low of 1.90 percent on Oct. 2 to 2.26 percent as of 7:26 a.m. Monday in New York.
Moves in Spreads ‘Symptomatic of Deeper Problems’
Longer term, JPMorgan Chase & Co. estimates the U.S. government may face $260 billion in additional interest costs over the next decade as a consequence.
“This is not really just a somewhat esoteric story about interest-rate derivatives,” strategists led by Joshua Younger wrote in a Nov. 6 report. “Moves in spreads should be viewed as symptomatic of deeper problems.”
Another potential problem is that inverted swap spreads may ultimately cause investors and borrowers to lose confidence in the bond market’s ability to correctly price risk and provide capital to those who need it, according to Steve Major, head of fixed income research at HSBC Holdings Plc.
Demand for swaps, which has boomed in recent years as companies that issued fixed-rate bonds used the contracts to hedge away the risk of changing Treasury yields, also serve as benchmarks for a variety of debt, including mortgage-backed and auto-loan securities.
“The role of the bond market is to provide funding at the right rates for the real economy,” Major said. “That’s why the bond market exists—to help efficiently finance projects, businesses, etc. If that efficiency is undermined, it’s not going to be a positive thing for the economy.”
Whatever the reason, the severity of the distortions is unnerving many investors.
“What there doesn’t appear to be is any single smoking gun that says why swap spread changes have been so dramatic,” said Thomas Urano, a money manager at Sage Advisory Services Ltd., which oversees $11 billion. The big question remains whether there is “something bigger brewing under the surface that so far hasn’t been pinpointed yet.”
–With assistance from Alexandra Scaggs and Kevin Buckland.