Treasury Anomalies: Disruptions in the Relationship between Swaps and Bonds

The events in the long end of the Treasury market and the swap market have been both dramatic and interesting the last day or so. The dramatic event is the flattening of the 10 year/30 curve in the swap market and its unintended consequences in the Treasury market.

The flattening in the swaps curve resulted in European swaps desks receiving in the swaps market to hedge exposure to exotic trades which were premised on the faulty notion that the swap curve could never invert. Anyway, some of that hedging percolated over to this side of the pond and resulted in some Treasury market anomalies.

In a normal environment the risk free Treasury asset will trade expensive to swaps. If one receives in the swap market, you have counterparty risk from whoever pays you. That risk is certainly subject to whatever type of collateral agreements the parties put in place as a piece of their ISDA agreement, but however ironclad the ISDA appears, the risk is far greater than one has when the US Treasury is on the other side.

So for the great, great, preponderance of time, if one takes a spot on the yield curve and simultaneously observes the relationship between a Treasury at that point and between the yield on receiving in a swap, the swap rate is always cheap to the Treasury.

The wild movements in the market have temporarily altered those relationships and there are Treasury securities that are trading cheap to the comparable point on the swap curve. For example, the November 21 zero coupon Principal was quoted this morning at swaps plus 28 basis points. That zero coupon bond traded 20 basis points rich to Libor about a month ago. Separately, the 5.5 August 15 2028 whole bond was swaps plus 13 basis points. That bond traded swaps minus 15 basis points a month ago.

In the past it has been a great idea to get long the Treasury against swaps when the spread was less than Libor less 10. A long bond trader with whom I spoke said that hedge funds would swarm to establish positions at Libor minus 9 and typically one could book 10 basis points to 15 basis points profits on those trades.

But alas the best laid plans of mice and men often go astray and there are many who are now trapped in bad positions.

What a difference a day makes, though.

The taxpayers recouped some of the gargantuan losses they suffered yesterday with the hasty auction of reopened 10 year paper which now resides in the 6 year part of the curve.

The Treasury sold $10 billion February 2015s and that issue stopped 4.2 basis points through screen levels.

Mr Paulson also sold $10 billion February 2018s  and that stopped 2.5 basis points rich to prevailing market levels.

I will offer an answer later regarding the question of how or why an auction would trade rich to market levels

Comments

[whidbey:]

Your pondering is useful, but it hardly reaches the issue of the CDS in general which present not just spill over problems in hedging, but fundamental risks of their own since most are not secured by very much in relation to the risk they cover and many of the counter-parties have suffered huge losses. If we see the insured corporation paper and bonds get into difficulty (and here will be a number in the high yield area), it will make the credit crunch look like a picnic. Most swaps are sold naked and most sellers utterly unable to response in settlement. Then maybe the world comes unglued since there are 50-70 trillion dollars worth out there, some where, nearby, too close for comfort.

2008 Oct 09 01:31 PM

[jswede:]

that's because he is talking about INTEREST rate swaps, not credit default swaps.

2008 Oct 09 04:39 PM

[Socialism c...:]

50-70T? Try 500T. Can you say...toast!?

2008 Oct 09 05:32 PM