Oct

23

See chart showing the relation between 30 yr swap spreads and 5 yr swap spread going back to 1994.

The current situation seems incredibly absurd to me– can any readers offer some insight into the economic/financial implications of this? It seems to me that the 30-yr swap spread is utterly out of whack (the 5-yr swap spread is also pretty darn low considering the distress in the banking sector; see this for more on why I think that. In fact, the 30-yr swap spread recently turned negative! (it's now hovering above zero). Consider for a moment what a negative 30-yr swap spread implies. For one, it is saying that the full faith and credit of the US Treasury isn't as good as an unsecured obligation of some shaky banks. But going beyond that, suppose the 30yr swap spread remains near zero. That would means that, if I had a $1b floating rate loan at say, 50 over libor, someone would be willing to lock me into a fixed rate for 30 years, and the rate I could lock it in at is the yield on the 30 yr treasury bond. Now, as we all know, treasuries are pretty expensive at the moment — flight to quality and all that. This statement is of course more applicable to short maturity Treasuries, but it is still the same underlying credit for the 30 yr. Now, I don't know about you guys, but with the way the fed has been printing money lately (see Federal Reserve release, +$245b in a week, and it's much worse, because as you can see, in that last week they sold a bunch of treasuries and replaced them with… crappy assets from banks), I can easily see Libor getting up to very high single digits over the next 10 years.

So what's going on here? What has caused this dislocation? Let's see what the fixed income mavens have to say about this.

Convergence trade anyone? Would be easy to put on — just pay fixed on a 30 yr interest rate swap, and then receive fixed on a 5 yr swap. You could lever it up pretty ridiculously too, as long as you had some cash put aside so you could stay in the game if this madness got even worse.


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5 Comments so far

  1. michael bonderer on October 23, 2008 7:54 pm

    my initial instinct is that this highly unusual situation is due to supply/demand imbalances; specifically a higher demand by those seeking to receive the fixed payment stream, perhaps from total rate-of-return accounts that need to hedge long-term liabilities? retiree payments. a contributing factor may be from treasury/FDIC decision to guarantee inter-bank lending, thus causing LIBOR to fall and thus making the floating side, to make payments in LIBOR, again relatively more attractive? it's interesting. treasuries are guaranteed, whereas swaps aren't, but the swap spread on the fixed side is now negative. this happened many years ago when the swap market was just getting going when sallie mae was the main counter-party and there existed a supply/demand counter-party imbalance as well.

    interestingly, we have the novomber refunding coming up and i presume we will see a greater then expected suplly of 10s and 30s, so given the fact that 30s have plunged like 25 basis points in 2-days, we may be setting up a terrific short trade in bonds?

  2. Anonymous on October 23, 2008 8:17 pm

    The rumor on the Street is that there are still bad positions in exotic derivative trades. The required dynamic hedging of such positions will often force receiving in 30-yr swaps.

  3. Anonymous on October 24, 2008 8:20 am

    Here's an FT article on the negative swap spread . As I mentioned before, there are plenty of bad exotic derivative trades hanging out there….and participants are scrambling.

  4. David on October 26, 2008 9:16 pm

    Not just receiving in 30yr swap spreads - because the problem is wicked negative convexity, it will swing back and forth - just check out the 10yr swap rate vs. 30yr swap rate (the steepener). In Europe as well as the US. An alternative explanation (alternative to this convexity story) is that the US gov’t is not that good of a credit in the long term, at least not relative to the best banks in the world (if I remember correctly, there is a mechanism for moving banks in and out of the basket). As to the point about banks being shaky, they are effectively gov’t guaranteed for the short run. Whatever the driver, this trade is essentially an unbounded relationship that is, in my view, even more dangerous than most because it is viewed as a bounded relationship by many market participants due to past recent experience.

  5. Anonymous on October 28, 2008 7:55 am

    “An alternative explanation (alternative to this convexity story) is that the US gov’t is not that good of a credit in the long term…”

    That’s quite an extrapolation given the spread in systemic risk across emerging countries and the ultra-delayed timing of the ECB and European authorities to address the current crisis.

    Occam’s razor is in order here…

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