In an orthodox yield curve environment, the interest-rate swap curve lies above the Treasury yield curve, because the latter represents US government credit risk and so is theoretically credit risk-free. The interest-rate swap market represents the inter-bank market, and so reflects the general creditworthiness of banks. If we look at the short end of the US Treasury and US dollar swap curves, we observe this conventional structure.
Since the onset of the financial crisis however, the long-end of the curve, represented by the 30-year swap and the Treasury long bond, has reversed and is showing a negative swap spread, with the interest-rate swap fixed rate lying below the equivalent Treasury yield. This defies conventional analysis and we need to consider what the market is telling us and the US government.
| US dollar 30-year swap spread to Treasuries | |
| 31-Jan-08 | +44 bps |
| 31-Jan-09 | -26 bps |
| 29-Jan-10 | -7 bps |
| 15-Apr-10 | -23 bps |
| (Source: Bloomberg) | |
We dismiss any notion that the spread is negative because inter-bank credit risk is now lower than US government credit risk. This is clearly not the case when one remembers that the banking sector was bailed out by the government.
Supply-and-demand is a first but only very partial explanation. The demand for long-dated hedging has increased considerably since the crisis, forcing swap dealers to mark down the long end. However bond investors who wish to convert their holdings into a floating-rate return via an asset swap are counterbalancing much of this demand. What the negative 30-year spread really means is that while the market expects the inter-bank sector to improve over time, it is far less certain in that with respect to government fiscal management and future long-dated yields.
Observation of long-run average swap spreads shows that the spread narrows as investor confidence increases. Generally when this happens the Treasury yield is also falling. Since the crisis we have observed a paradoxical situation developing where the market expects the private sector to improve but not necessarily the public one. The issues of concern are (i) the increasing public sector deficit, and its future management (ii) the expectation that the base rate will remain low for some time even once it starts being raised by the Federal Reserve, with consequent inflationary risk and (iii) a longer-than-average interest rate cycle, creating uncertainty as to what the ceiling for rates will be. These factors all point to increasing Treasury yields over the medium term.
In other words, a swap dealer writing a 30-year swap ticket today expects the 30-year Treasury yield to be rising during the life of the swap, but the 30-year swap rate to be falling. It is a future expectation of Treasury yields that creates this result, rather than perceived credit risk or simple supply and demand. This situation will continue until the market is more certain about the direction of US fiscal and monetary policy.
The writer is Visiting Professor at the Department of Economics, London Metropolitan University, and author of Bank Asset and Liability Management