Rates Outlook: Swap Spreads To See Widening Pressure

Dec. 10, 2021 8:20 PM ETIEF, TLT, TLH, PLW, EDV, SPTL, ZROZ, VGLT, LGOV, SCHQ, TFJL, TBJL, GOVZ, TBT, TMV, SHY, TBF, TMF, PST, TTT, IEI, BIL, TYO, UBT, UST, VGSH, SHV, VGIT, GOVT, SCHO, TBX, SCHR, GSY, TYD, DTYL, EGF, VUSTX, DTUS, DTUL, DFVL, TAPR, DFVS, FIBR, GBIL, EUFN1 Comment2 Likes

Summary

  • While there is upward pressure on market rates in 2022, it's not coming from higher net supply. In fact, lower net supply can help to richen government bonds.
  • On top of that, we should see flatter curves over the whole of 2022. We also anticipate some upward pressure on USD Libor.
  • Room should be made for hikes through 2022, with the US 10yr pivoting higher first in the first quarter.

Blue Financial Graph Background - Stock Market and Finance Concept

MicroStockHub/iStock via Getty Images

By Padhraic Garvey, CFA and Antoine Bouvet

While there is upward pressure on market rates in 2022, it's not coming from higher net supply. In fact, lower net supply can help to richen government bonds. On top of that, we should see flatter curves over the whole of 2022. We also anticipate some upward pressure on USD Libor. And we expect an overshoot in the spread from eurozone to US rates vs equilibrium.There are three factors that should contribute to some widening pressure for US swap spreads.

First, there should be less net supply pressure as we progress through 2022, at least versus 2021. Even when we take account of the end of Federal Reserve buying, there is a reduction in overall net supply pressure, to the tune of $0.5t. This should help to richen government bonds in a relative sense.

Second, as the Fed hikes rates later in 2022 there should be a clear flattening pressure right along the curve. A flatter curve typically correlates with wider swap spreads on the theory that extensions provide less compensation for spread product, so there is pressure for wider spreads to compensate.

Third, credit conditions are expected to tighten as we progress through 2022. This, in all probability, will place upward pressure on USD Libor rates, reflecting higher required rate prints on financial commercial paper issuance. This should be reflected in upward pressure right along the USD Libor curve.

This also correlates with upward pressure on 3-month USD Libor rates versus 3-month SOFR as we progress through 2022.

Swap spreads aren’t necessarily the area where one would expect central bank tightening expectations to be the most clearly priced in. In theory, this leaves them free to reflect the usual technical factors that normally affect the differential between swap rates and government bonds. This is only true up to a point.

The reduction in ECB excess liquidity should strengthen expectations of wider Euribor-OIS spreads. This could in theory be offset by the cheapening of government bonds as year-end distortions ease and as the ECB tapers its purchase programmes.

In reality, we expect bond scarcity to remain largely prevalent throughout 2022 with no meaningful ability to impact swap spreads with a durable effect, save for a knee-jerk cheapening in early January as bank balance sheet constraints ease.

Investors' hedging behaviour will gain in importance as 2022 progresses. Bond scarcity has boosted the directionality of short-end swap spreads (widening on greater hike expectations) and we expect this dynamic to progressively spread to longer tenors as borrowers increasingly see the appeal of fixings their liabilities.

This factor is the hardest to quantify as it mostly depends on whether and when the reality of higher rates dawns on market participants but, as the year progresses, we expect the consensus to move in that direction, keeping swap spreads at wider levels than in the past year.

Demand to fix liabilities will keep EUR swap spreads wide

Refinitiv, ING

US versus Euro market rates: Widening pressure

Room should be made for hikes through 2022, with the US 10yr pivoting higher first in the first quarter. The current spread from the Euro 10yr to the US 10yr is 145bp. We expect this to stretch to 175bp as the US macro story and forward rate hike narrative leads the eurozone one.

From the second quarter, front end rates in both the US and eurozone should come under upward pressure, re-flattening curves. As this will be led by the US 2yr, its spread versus the eurozone 2yr should come under widening pressure. The current eurozone to US 2yr spread is 120bp. We can see this stretching to the 200bp area.

Both the 2yr and 10yr spreads between the eurozone and the US will find a more natural equilibrium in the 150bp area, which by extension points to the above widening targets as overshoots. This 150bp valuation is not overly stretched as we'd continue to identify a buying/receiving pressure on US rates reflecting their relative elevation versus comparables.

Content Disclaimer

This publication has been prepared by ING solely for information purposes irrespective of a particular user's means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Read more

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

This article was written by

From Trump to trade, FX to Brexit, ING’s global economists have it covered. Go to ING.com/THINK to stay a step ahead. We’re sorry we can’t reply to individuals' comments.Content disclaimer: The information in the publication is not an investment recommendation and it is not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument.This publication has been prepared by ING solely for information purposes without regard to any particular user's investment objectives, financial situation, or means. For our full disclaimer please click here.
Follow

Recommended For You

Comments (1)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.