Market distortions in supply or demand will show up in prices, but the reasoning may not always be obvious. This is the case in swap spreads along the yield curve. We do not pretend to solve this issue but highlight this market distortion. The standard view on swap spreads is that they should always be higher than Treasury yields for the simple reason that risky assets should always trade at a yield premium to less risky assets. Yet, in the current swap market that is not the case. We have seen long-term swaps turn negative after the 2008 Financial Crisis and have for the most part they have stayed that way. Now we have negative swap spreads down to 7-years and 2-year swaps hovering at zero. This does not make sense in a world where swaps are risky than Treasuries, so that means one of two things. Either the world is abnormal or the assumption that there is a risk premium that should always be positive is wrong. The possible reasons for a negative swap spread have mixed rationale, but we are in the camp that there is not an abnormality but a refection of segmentation.
Here are some reasons for what could cause spreads to tighten and fall below zero:
Treasuries are riskier than swaps. This would means that the probability of payment of principal and interest for a government bond is less than a swap. This is highly unlikely, but could be possible if you consider that a swap is with differential cash flows and not a payment of interest and principal. The risk of the swap is the replacement cost of rates at the time the swap is adjusted or offset. This a possible explanation, but someone has the explain why the swap rates have gone negative during a crisis and more recently.
There is more corporate hedging. This will cause tightening, but it cannot explain why spreads will go negative. The answer that hedging is so great that it offsets credit risk seems to be a hollow rationale.
The yield curve is steepening. This makes sense that the spreads will tighten in a steepening yield curve, but it does not make sense that the spreads will move through zero. There has been work on decomposing the behavior of swaps spreads. Josephine Smith from NYU has looked at the principal components of swap spreads and shows that the sensitivity is highly variable, yet this uncertainty does not translate to negative swap spreads.
Swap spreads reflect the different between LIBOR and repo. The TED spreads has been widening over the last year albeit it has not been anywhere close to the 2008 period or the 2011-2012 period. In this case, you can finance bonds with repo, pay fixed to receive LIBOR. The financing argument seems to make more sense, but it cannot explain why some parts of the curve will go negative and others will not. Certainly, this type of financing argument is harder to use for long periods.
Supply and demand issues. If there is excess supply of governments, they can cheapen relative to swaps. This can create a situation where swap spreads are negative because there are limits to arbitrage and there is no one willing to do a swap to collect the better rates. When there is massive new supply, selling pressure, or high uncertainty that will preclude swap activity, there will be the chance of a negative spreads. This seems to be a likely scenario that can explain some of the recent facts. This argument rests on the idea that there is market segmentation that can be so great that there is not enough capital to bring the swap and Treasury markets not alignment. With capital charges for holding bonds different than swaps, financing uncertainty, and large selling or buying activity from central banks, the segmentation argument can provide a story that seems reasonable. Regulatory changes have distorted the movement an commitment of capital. We are not arguing that this is inherently bad, but it is a cause.
Market distortions are important to watch because they will spillover to other markets and great more opportunities for those that are not financially impaired.
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