Sign of Another Bubble: Swap Rates Lower Than Treasuries

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Includes: IYG, QQQ, SPY
by: Bo Peng

As reported by FT, long-term dollar swap rates dropped below yields of treasuries with same maturity this week. The last time this happened was in March and it ended in April. We know what happened shortly afterward.

In a nutshell, this is probably what happened. Some fund managers (no doubt the type who only care about relative performance, meaning their bonus/jobs are safe if they lose 10% when the market drops 10%) came to TBTF banks and begged them to sell some bonds. TBTFs said "heck, why not, as long as rates are low." So they sold over $7B of it last week, at very low rates, probably using it to roll over maturing debt sold in past years at much higher coupons. Since a bank's revenue is generally tied to short-term interest rates, it's standard practice for banks to swap a large portion of their fixed-rate liability (bonds) to floating rates. Large buying of the fixed leg of interest rate swaps drives down the swap rate.

The TED spread is the difference of 3-month Libor and 3-month T-bill, which has been essentially 0 recently. It's a measure of perceived short-term credit risk of banks as a sector. For longer term, the corresponding measure is the swap spread over treasuries. So, if you were to believe this, the market is saying TBTFs have the same credit risk as Uncle Sam's in the short-term, and lower in the long term. This is of course absurd. No matter how you feel about TBTFs or US sov credit, the moment Uncle Sam defaults, TBTF is no longer.

When significant market dislocation occurs, it's one of two things: panic or bubble. You could call bubble "panic buying" and further reduce it to one thing: panic. When someone is willing to lend 5-year money to TBTF for 0.75% more than treasuries, it's panic buying. It's someone playing with others' money and whose goal in life is to get 0.01% higher than treasury, for this quarter/year. This is pathetic. This is stupid. This is exactly what happened in 05-06 and the past March/April.

I called an imminent correction in early May (somebody copied it to NASDAQ forum?), and one of the triggers that got me thinking about it was the fact that junk bonds were trading near par. This didn't make sense. It was desperate, nonsensical, stupid, panic buying.

Now we have another, very significant, sign of another bubble, a mini-bubble in the bond space. One could argue treasuries have been a bubble since at least May, but it may go on for awhile just for lack of alternatives.

I also said repeatedly that a consequence of bailouts and QE is a series of bubbles created by force-fed money sloshing around seeking relative return.

We shall see when this one goes bust.

And, if your fund recently bought bank bonds, get out of there ASAP.

As to banks that just levered up a notch by selling bonds and then swapping them for floating, they made a multi-billion dollar bet that interest rates will stay low or get lower for 5 years or more. This is a very bearish bet -- they're essentially betting on delfation or, at best, stagnation for years to come. Never mind what their economists and research reports say, but watch what they do. The talk has been overwhelmingly bullish (as always), but I'm glad they agree with me in action.

Finally, what happens to those who sold them those swaps, paying fixed and getting floating? If/when interest rates go higher, they'll have counterparty credit risk exposure to TBTFs. They may be buy-side funds, but probably mostly TBTFs themselves. The tangled web of counterparty risk just got a bit more tangled, further ensuring chain reaction mechanism and creating more risk without any macroscopic benefit.

Disclosure: Long SPY puts