Something very strange is happening in the world of fixed income. Across developed markets, the conventional relationship between government debt–long considered the risk-free benchmark–and other assets has been turned upside-down.
Nowhere is that more evident than in the US, where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks. But these days, it’s just the opposite as a growing number of treasuries yield more than interest-rate swaps. The same phenomenon has emerged in the UK, while the “swap spread” as it’s known among bond-market types, has shrunk to the smallest on record in Australia, Bloomberg reported.
Part of it simply has to do with the fact that investors are pushing up yields on treasuries–which guide rates for just about everything–as the Federal Reserve prepares to raise borrowing costs for the first time in a decade. But in many ways, it reflects the unintended consequences of post-crisis rules designed to make the financial system stronger. Those changes have made it cheaper and safer to use derivatives to hedge risk, and more onerous and expensive for bond dealers to make markets in the safest securities.
“These kinds of dislocations can be expected to grow over time,” said Aaron Kohli, a fixed-income strategist at Bank of Montreal, one of 22 primary dealers that trade directly with the Fed. “The market structure and regulatory structure has evolved in a period with very low volatility. Once you take that away, it’s not clear what the secondary implications of that will be.”
Illogical Relationship
It’s hard to overstate how illogical it is when swap spreads are inverted. That’s because it suggests that governments are less creditworthy than the very financial institutions they bailed out during the credit crisis just seven years ago. And as the Fed prepares to end its near-zero rate policy, those distortions are coming to the fore.
The rate on 30-year swaps, which allow investors, companies and traders to exchange fixed interest rates for those that fluctuate with the market, and vice versa, has been lower than comparable yields on treasuries for years now as pension funds and insurers increasingly hedged their long-term liabilities.
But in the past three months, spreads on shorter-dated contracts have also quickly turned negative. Now, five-year swap rates are about 0.04 percentage points lower than similar-maturity treasuries, while those due in three years are also on the verge of flipping.
As the phenomenon becomes more widespread, it adds to evidence that it’s not just a one-off, according to Priya Misra, the New York-based head of global interest-rate strategy at TD Securities, another primary dealer. “Everybody in the fixed-income market should care about this,” she said.
In the UK, where the Bank of England is also debating whether to raise rates, the swap spread reached minus 0.05 percentage points on Nov. 12, the least since December 2013. The difference between 10-year Australian notes and comparable swaps fell to a record last week as speculation diminished the central bank will cut borrowing costs.
