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.
Five-year spreads turn negative
Nowhere
is that more evident than in the U.S., 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 U.K., while the “swap spread” as it’s
known among bond-market types, has shrunk to the smallest on record in
Australia.
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 then 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 0.05 percentage
points lower than similar-maturity Treasuries, while those due in three
years are also on the verge of flipping.
Swap Rates Plunge Below U.S. Treasury Yields
Widespread Phenomenon
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 U.K., 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.
“Traditional
pricing and relative-value rules are breaking down,” said David
Goodman, head of global capital markets strategy at Westpac Banking
Corp.
In a recent report titled the “Global Regulatory Crisis,”
Goodman pointed to regulators’ efforts to head off another crisis as one
of the reasons for the shrinking spreads.
Regulatory Crisis
One
of those rules has moved swaps to central clearinghouses, which has
pushed down costs by eliminating most of the counterparty risks of
trading directly with banks. Another has been the so-called
supplementary leverage ratio, an addendum from U.S. regulators to global
capital regulations known as Basel III. In one part of the provisions,
government bonds are considered just as risky as corporate debt.
First decline in two years
That’s
made banks less willing to own sovereigns and pushed them toward swaps,
which eat up less cash and aren’t subject to the same capital
requirements. U.S. commercial banks cut their Treasury holdings for the
first time in two years in the three months ended September, even as
their total government debt positions, including those backed by federal
agencies, have continued to rise, Fed data show.
“We saw a lot of
this accentuated at the end of September,” said Yvette Klevan, a
fixed-income manager at Lazard Asset Management, which oversees $165
billion. “They wanted to clean up their balance sheets by reducing bond
inventory.”
With China
poised to cull its U.S. debt holdings for the first time since 2001,
the decline in demand is contributing to higher borrowing costs. Yields
on 10-year Treasuries have climbed from a low of 1.90 percent on Oct. 2
to 2.26 percent as of 7:26 a.m. Monday in New York.
‘Deeper Problems’
Longer
term, JPMorgan Chase & Co. estimates the U.S. government may face
$260 billion in additional interest costs over the next decade as a
consequence.
“This is not really just a somewhat esoteric story
about interest-rate derivatives,” strategists led by Joshua Younger
wrote in a Nov. 6 report. “Moves in spreads should be viewed as
symptomatic of deeper problems.”
Another potential problem is that
inverted swap spreads may ultimately cause investors and borrowers to
lose confidence in the bond market’s ability to correctly price risk and
provide capital to those who need it, according to Steve Major, head of
fixed income research at HSBC Holdings Plc.
Demand for swaps,
which has boomed in recent years as companies that issued fixed-rate
bonds used the contracts to hedge away the risk of changing Treasury
yields, also serve as benchmarks for a variety of debt, including
mortgage-backed and auto-loan securities.
Smoking Guns
“The
role of the bond market is to provide funding at the right rates for
the real economy,” Major said. “That’s why the bond market exists -- to
help efficiently finance projects, businesses etcetera. If that
efficiency is undermined, it’s not going to be a positive thing for the
economy.”
Whatever the reason, the severity of the distortions is unnerving many investors.
“What
there doesn’t appear to be is any single smoking gun that says why swap
spread changes have been so dramatic,” said Thomas Urano, a money
manager at Sage Advisory Services Ltd., which oversees $11 billion. The
big question remains whether there is “something bigger brewing under
the surface that so far hasn’t been pinpointed yet.”
end quote from:
http://www.bloomberg.com/news/articles/2015-11-15/debt-market-distortions-go-global-as-nothing-makes-sense-anymore?cmpid=yhoo.headline
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