Swap spread is defined as the difference between the fixed rate on an interest rate swap and a similar-maturity Treasury yield. The regulatory requirement for central clearing of interest rate swaps has removed counterparty risk from swap contracts, and nowadays the swap spread is negative across all maturities. Swap spreads have tightened and Treasury yields have rallied significantly this year. This week’s chart discusses the implied reasons and trends for this phenomenon.
As noted in the chart, swap spreads tightened in line with the rally in interest rates. This is largely driven by convexity hedging activities from mortgage investors and variable annuity (VA) issuers. With negative convexity, mortgage duration shortens when rates rally, and mortgage investors need to purchase duration to keep portfolio duration flat. Since VA reserve increases with a lower discount rate, VA issuers observed longer liability duration. As a result, VA issuers tend to buy duration on the asset side to keep net duration flat. The easiest way to add duration is to enter into receiver swaps, which drives swap rates lower and tightens swap spreads.
Since the rally in interest rates usually coincides with a cyclical slowdown, period tax revenue falls and budget deficits escalate as a result, leading to increased government borrowing. Higher borrowing costs increase Treasury yields and cause a tighter swap spread. Besides, the U.S. dollar becomes more attractive in an uncertain economic environment. Countries with a relative low currency swap spread rate tend to issue debt in USD and then receive a fixed swap rate in USD, generally driving the swap rate lower.
This year’s swap spread tightening has been accelerated by the U.S.-China trade war. In the past and going forward, if China wants to defend USD/CNY against rising above seven, the selling of Treasury bonds would drive yields higher.
As year-end approaches, there is increasing Treasury repo funding pressure, which will drive swap spreads tighter. This is because when paying fixed in swaps, the LIBOR rate is earned while the repo rate is paid to finance a long Treasury position. As LIBOR-repo becomes tighter, carry of this spread widener trade worsens and there will be lower demand for paying fixed, which drives the swap rate lower. However, as the Federal Reserve (Fed) intends to introduce a standing repo facility the repo rate is expected to stabilize once it’s put into use. I anticipate this introduction may have more of an impact on front-end swap spreads.
The degree of swap spread compression has resulted from the supply/demand imbalance of interest rate swaps and bonds. In recent years, I’ve observed that the swap spread tightens when rates rally and widens when rates sell off, but the pattern has changed over time. Before the global financial crisis, when VA issuance was much lighter and liquidity consideration was not so intensive, swap spread didn’t show such a strong correlation with the change in rates. For the rest of 2019, as the Fed continues to ease, deficit expectations grow and the USD strengthens, I expect the long-end swap spread tightening trend to continue.
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