FT Alphaville has written about the (new) negative territory being experienced in US government swap spreads – the 10-year government swap, to be precise.
On Tuesday, however, that spiral descended further, taking in the 7-year swap spread (H/T Alea).
The Bloomberg table below, for example, shows the 7-year swap was trading at a negative 0.25 basis points spread on Tuesday afternoon in London:
The 10-year swap spread, which turned negative for the first time on March 23, was trading at a negative 4.63bp.
So is all this negativity cause for concern?
Before we answer that, it’s worth reiterating that a negative swap spread simply means that the Treasury yield is higher than the swap rate, which as Bloomberg explains is traditionally greater because it is derived from floating payments based on interest rates that contain credit risk, such as the London interbank offered rate.
In a sense, therefore, the negativity suggests Treasury yields are no longer a reflection of the true cost of risk-free borrowing. But while that might be connected to genuine market concerns over the credit quality of the issuer, it could also be related to good old fashioned supply and demand fundamentals.
Jim Reid at Deutsche Bank put it well on Monday:
So for now Sovereign risk is a double-edged sword with some fascinating benefits to offset the obvious negatives. Lower Treasury yields has been one such gain and secondly we’ve had the unique situation where last week US 10 year swap spreads turned negative for the first time on record.
UK swap spreads have been negative for a few weeks now. Ultra tight (and negative swap spreads) are wonderful conditions for holders of spread product which in turn has the ability to increase confidence in equity markets.
Indeed in the early years of my career in credit markets, swap spreads were the most important performance variable I tracked. In this cycle the market has been less focused on it. This is probably because investors are far more credit focused now than they were 10-15 years ago. Back in those days we always argued against those that said that swap spreads were a proxy for AA bank credit risk.
We thought and continue to think that swap spreads are mostly a function of the relative supply (and demand) for Government bonds. Its no coincident that the all-time wides for swap spreads occurred in early 2000 when the market was pricing in almost permanent Government bond buy backs and the possible elimination of Government debt.
Swap spreads gapped wider and credit had a very hard time. Today with government issuance likely to remain high for as far as the eye can see it therefore stands to reason that swap spreads should be very low. Only in times of severe stress do swap spreads reflect credit risk. Outside of this its all about relative Government bond supply.
Barclays Capital has also warned that the market could be skewed by the repo market’s inability to easily absorb the extra $200bn worth of collateral supply created by the Fed’s re-introduction of the Supplementary Financing Programme.