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Pensford Brief – Negative Swap Spreads No More?

A pretty big event happened today that you’re probably not going to hear about on CNBC. The 10-yr swap spread is pushing out of negative territory.

Source: Bloomberg Finance, LP

Swaps Spreads Moved Negative

In September 2015, the spread between the 10-year Treasury Yield and the 10-year Swap yield went negative for the first time in history. It was a pretty notable move, since the 10-year swap was supposed to represent the risk of large banks (which, if you remember, had failed spectacularly less than a decade before) and the 10-year Treasury was supposed to represent a near-riskless return.

So what happened? The short version is tighter banking regulation, which dictated the kinds of assets banks could hold on their books, forced swap rates down, while a looming tightening cycle pushed investors out of Treasurys, sending prices down and yields higher. 

Swap Spreads Move Towards Positive Territory

That brings us back to today. Why have spreads narrowed so much that we’re back to 0?

  1. June 12, 2017. The US Treasury Dept released a report that outlined a series of recommendations to streamline capital requirements for small banks and general deregulation to promote lending and growth.
  2. October 6, 2017. The US Treasury Dept released another report that offers a guide to the SEC and CFTC (the group that regulates swaps) on how the agencies should enforce policy – namely, that market restraints should be loosened.

These reports, and two more expected in the coming months, originate from an Executive Order President Trump signed in February asking Treasury Secretary Steven Mnuchin to reposition financial rules to better match the Administration’s aims. This has analysts predicting that Treasurys may be set to become more liquid and cheaper for banks to hold on their balance sheet.

The recent nomination of Fed Governor Jerome Powell to replace Janet Yellen as Fed Chair is playing a part as well. Powell is perceived to be supportive of deregulation, and his nomination is being factored into many analysts’ predictions of swap spreads widening in 2018.

Traders are also monitoring the progress of tax-overhaul legislation, which could crimp corporations’ ability to deduct debt-interest costs from earnings and make it more attractive for companies to bring home overseas cash. The net effect would reduce the demand for swaps, putting pressure on spreads to widen.

Back to Normal?

Even though spreads seem to be moving back into positive territory, it’s unlikely that we’ll see them moving back to historical levels (good news for CMBS borrowers). There’s several reasons for this:

  1. Because of Dodd-Frank, the vast majority of swaps are still centrally cleared, removing counterparty credit risk, which pushes swap rates down.
  2. Regulatory change moves at a glacial pace. Given the complexity of the regulatory environment and army of regulatory agencies that enforce it, it’s certainly possible that the current move is overdone. A series of recommendations is by no means a near-term change that will quickly free up balance sheets at major banks.
  3. Tax Reform is still up in the air. The final version of the bill could be different than what traders are pricing in today.

At the end of the day, the widening effect on spreads is just based on speculation. Not much has to go wrong for the trend to reverse: failure to pass tax reform, Powell doesn’t pass his Senate Confirmation, or financial regulation changes take longer than expected to get implemented. There’s a lot of technical factors at play here too, but hopefully this will help highlight some of the more immediate reasons.

As always, we’ll update as more information becomes available. Have a Happy Thanksgiving.