Thursday, December 22, 2011

Equities and swap spreads - misbehaving again

The saga of diverging risk indicators continues. Today the contradiction could be observed intraday. The equity market rally was fairly sustained.

S&P500 Futures (Bloomberg)
As expected, credit spreads tightened.

Investment Grade CDX
...yet the rally in stocks was coincident with a sharp widening in swap spreads.

USD 2-year Swap Spread
Typically equity prices and swap spreads move in the opposite direction, with a correlation coefficient of around -0.4.  Swap spreads are market expectations of future LIBOR spreads to treasuries.  When LIBOR is expected to stay elevated relative to treasury yields, it points to uncertainty in interbank funding - an indication of risk. At 49 bp USD 2-year swap spreads continue to be elevated relative to the post-2008 history.  One possible explanation would be that as equities rally, traders are protecting the downside by going long swap spreads (given that equity puts have not been as effective).  Swap spreads are sometimes viewed as cheap "tail risk" protection and the current uncertainty dictates that some protection is quite necessary.
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