Three reasons for extremely low swap spreads

US swap spreads continue to decline, as the 5y spread hovers below 10bp. A rate swaps is basically a stream of floating (3m LIBOR) vs. fixed payments. The level at which fixed payments are set (the swap rate) is therefore the market's projection of future LIBOR. This decline in spread is the market's expectation that future LIBOR to treasury spreads will be lower. Three factors are contributing to this decline:

1. With the ECB backstop to the Eurozone sovereigns in place, the perceived risks to global banks have subsided. Improved health of the global financial system means lower cost of funding for banks, which should (loosely) translate into lower LIBOR to treasury (TED) spread in the future - thus lower swap spread.

2. As LIBOR converges to CD rates (see discussion), which have generally been lower, the market is pricing in lower overall LIBOR levels in the future (reducing swap spreads).

3. The Fed has been taking duration out of the market, first via Twist (see discussion on how Twist reduced duration) and now also with MBS purchases (see discussion). With mortgage refinancing accelerating, MBS durations decline. When fixed income investors hedge against rate risk, they usually want to pay fixed and receive floating on a rate swap. But as the need to hedge fixed income portfolios declines (because portfolios have lower durations) so does the demand to pay fixed - which reduces swap rates and spreads.

If anything, investors now want to receive fixed on rate swaps to synthetically increase their portfolio durations. An example of that may be a life insurance company that has long-term liabilities (death benefits) and needs long term assets to avoid a duration mismatch.

5y Swap Spread (source: FRB)

Note that the bump in swap spreads during the May-June period was all driven by the Eurozone, as LIBOR to treasuries spread widened and so did swap spreads. A change to any of the three factors above (like the May-June period) could reverse this trend. For now however the ECB, the Fed, and new LIBOR regulation should keep swaps spreads low.

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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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The steepening vol curve and more risk decoupling

Implied volatility continues to sell off, with VIX down 10% (of vol, not points) month to date. The sell-off is particularly strong for short-dated options as VIX futures curve continues to steepen. The chart below shows VIX futures one-day move along the curve, with the nearby contract coming off sharply.

(Bloomberg)

With bullish year-end calls, we continue to have a case of "cognitive dissonance" as risk indicators diverge.  Surprisingly this time we are seeing the decoupling of the USD swap spreads and the US implied volatility index.  The two-year USD swap spread is up 4 bp today, while VIX is down some 3%.  This indicates further decoupling of short term risks in equities from medium term bank funding risks.

(Bloomberg)

Given that funding risk is generally associated with banks, this divergence is also visible in the underperformance of the financial sector during the past week.  The chart below compares recent performance of XLF and SPY ETFs (financial sector vs. the overall market).

The broad interpretation here would be that Europe's problems may impact US financials, but in the short-term the US equity market risks have diminished.  Again if one disagrees with this fundamental view, this may be a good opportunity to put on a trade: for example long SPY puts, receive fixed on the 2-year USD swap, and short 2-year treasuries. 

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VIX and EUR swap spreads - two diverging risk indicators

Euro swap spreads have moved up materially today with the 2-year spread rising 6bp to 113bp - near recent highs. That is clearly an indication of financial stress. However another financial stress indicator, the VIX has been moving in the opposite direction (lowering put "responsiveness").

 VIX vs. 2-yr EUR Swap Spread (Bloomberg)

This divergence is  puzzling.  Fundamentally it expresses a "decoupling" between risks in the US equity markets and risks in the EUR interbank funding markets.  That decoupling is difficult to imagine because should there be a funding problem among European banks, it will definitely translate into risks in the equity markets.

Nevertheless the market is telling us that participants are pricing these two risks differently with continuing credit tightness in Europe not necessarily translating into a significant slowdown in the US corporate sector.  For those who feel the fundamentals don't justify such divergence, there is a trade in there somewhere.

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The Stability Union concept is not dampening financial stress indicators

The concept of the Stability Union seems to be getting traction.

Reuters: "We are working intensively for the creation of a Stability Union," the German Finance Ministry said in a statement. "That is what we want to secure through treaty changes, in which we propose that the budgets of member states must observe debt limits."

The discussion seems to focus around the full EU Treaty ratification with all the eurozone countries involved.  The thought is that if member states sign on to strict austerity (effectively as prescribed by Germany), the ECB would be more amenable to supporting the eurozone bond market.  It is hard to imagine this could be a quick process, given that it will involve member states' parliamentary maneuvering.  The Italian yield curve flattened in response, with inversion between the ten and the two year notes now at around 30bp.

Italy Yield Curve (Bloomberg) - still inverted
white - current, orange - Friday

The short-covering rally is extending across major equity markets - part of it driven by rumors that the Fed is gearing up for QE2 (more on that later).  However financial stress indicators continue to stay elevated.  It's hard to fully trust some of the confusing language coming out of Europe.  The chart below is the US 2-year swap spread which is maybe a basis point off the high.

 US 2-year Swap Spread (Bloomberg)

Similarly the 3-month EUR/USD currency basis swap spread continues to widen, marching toward -150.

3m EUR/USD currency basis swap spread (Bloomberg)

 The financial system, particularly in Europe is still quite stressed.  This is not going to change until we see a concrete and plausible proposal with full details emerging from the key members of the eurozone.

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Swap Spreads Strike Again

The Sober Look "we are back" post pointed to US swaps spreads as one of the key indicators to watch. Today the equity markets went into the "la la land" with the usual afternoon rally. After all Europe was closed, so what could go wrong? In the mean time the US swap spreads continued to widen, ultimately breaking 51bp (on the 2yr). That took the equity market down by over 1.5% in a violent last hour sell-off.

2Y USD SWAP SPREAD (Bloomberg)

 This is clearly an unsettling development because it indicates increasing concerns about interbank funding. A simple chart of US LIBOR clearly points to that.

3M USD LIBOR (Bloomberg)

Other interbank liquidity indicators such as the TED spread, the OIS spread, and US financials' CDS spreads are all higher as well (more on that later). Europe's open tomorrow is not going to be pretty.

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Europe's Unsustainable Markets

The situation in Europe feels unsustainable. The volatility comes and goes in waves, and each consecutive wave is worse than the previous. This morning Spain had a fairly bad bill auction (felt like Spanish banks ended up buying most of the paper) and European government bonds started unraveling. Spanish and Belgian bond spreads (to Bunds) hit new records. The most troubling is the selloff in French bonds. This is no longer the "fringe" of Europe, but the core. Below is the spread for 5-year French bonds - a new record.

Source: Bloomberg 

Simultaneously the interbank lending indicators continue to show stress. Below is a chart of the 2-year EUR Swap Spreads. We are now at levels not seen since late 2008.

Source: Bloomberg 

As scary as Europe looks, the US may be following a different path. More on that later on.

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Sober Look is Back

After a two-year hiatus, we are going to fire up the old Sober Look again. The goal this time around is to have less frequent postings but with more than one contributor. With all the macro fun that’s been shaking up the financial markets and all the hype that surrounds it, the time is right.

We start off with a simple chart of the USD 2-year swap spread. For those who are not familiar with the term, it’s the fixed rate on the current 2-year fixed-for-floating swap vs. the yield on a 2-year treasury note. This is basically the expectation of future LIBOR spread to treasuries. Today we’ve hit a new recent high, indicating concern about the health of the interbank lending markets. This is one of the key indicators of stress in the overall financial system. 47bp is no big deal relative to 08, but it’s something to watch closely.

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