What has happened?
It has happened in both the Sterling and the US Dollar bond markets. The 10s USD swap rate is now trading below the 10s USD govy rate for the first time as of yesterday. Such inversion was already in place in the 30s swap/Treasury end of the USD curve and now it has been extended to the middle section of the USD swap/Treasury term structure.
Why has it happened?
The inversion is being driven by a host of factors including hedging activity from broker dealers. High government bond supply is driving the govy yields upwards. Another factor helping cause the inversion is the increased demand by investors using swaps for meeting longer term liabilities rather than committing capital to buy longer maturity bonds. At present, there is a tangible attractiveness in using swaps as opposed to bonds as a means of financing. This is not too different to repo financing / wholesale funding type transactions being conducted through swaps. Large issuance of corporate debt which is swapped from fixed coupons to floating rates has also increased the likelihood of the inversion. Furthermore, the inversion in yields is likely being accentuated by technical factors - notably a number of structured derivative trades betting on the shape of the govy and swap curves cease paying a coupon when swaps trade below govies. Thus the unexpected inversion is leading to a surge in demand for hedging (so called negative gamma trap) that, in turn, has magnified the inversion.
In the Sterling markets, the 10s swap is already below 10s Gilts at 3.80 and 3.91 percentage points respectively. Similar to the US case, in the UK, pension fund demand has pushed swaps into negative spread territory as rather than commit cash to buying longer term bonds, funds have chosen swaps to lock in long term fixed rates. This is not surprising given the steep yield curves provide incentives to rollover short maturity funding to longer periods and the general paucity of long term funding sources given the uncertainty on the economic climate.
The inversion in the USD swap rates also reflects a lack of capital amongst market participants since an inversion in swap/govy spreads should, in theory, be arbitraged away. However, executing such an arbitrage trade depends on committing capital for an extended period. This has not been easy. 30s inversion shows the difficulty of financing long term balance sheet trades given the uncertainty ahead. 10s inversion is now showing similar difficulty in financing at the 10 year maturity horizons.
Risks Ahead?
The inversion is rare but not something that has not happened in the past. In normal markets, yields on govies trade at a discount to swaps as govies reflect AAA risk and swaps reflect counterparty lending risk. However, read in the context of blowing budget deficits, let us hope that the inversion is not spelling out more ominous signs such as an impending surge in govy yields that will increase funding costs of the Government and inevitably also lead to a rise in mortgage rates. That would be a double blow to deficits and housing that we could all do without.
The inversion is rare but not something that has not happened in the past. In normal markets, yields on govies trade at a discount to swaps as govies reflect AAA risk and swaps reflect counterparty lending risk. However, read in the context of blowing budget deficits, let us hope that the inversion is not spelling out more ominous signs such as an impending surge in govy yields that will increase funding costs of the Government and inevitably also lead to a rise in mortgage rates. That would be a double blow to deficits and housing that we could all do without.
Interestingly, the inversion in swaps ties in with the notion that sound US corporates like Berkshire are issuing debt at yields lower than that of debt issued by the US Treasury.
Aly Iman
Chief Strategist & Partner
risConometrics Inc.
Note:
PDF of this comment was forwarded to risConometrics' clients and is availalbe for download at
http://www.risconometrics.com/risConometrics_comment_032410.pdf
Blog: www.risConometrics.com/webblog/
Disclosure: None