Friday, 20 October 2017

When swap spreads are negative, it’s hard to be positive

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I CAN HARDLY imagine that the negative swap spreads in the US dollar have escaped anyone’s attention.

I got trapped by them myself when I couldn’t get my head around why I could buy a block of supranational 10-year bonds at Libor plus 95bp while I was being offered the same credit in the 30-year area at a mere Treasuries plus 95bp. Not until I’d checked back and found the massive anomaly in the dollar swap curve did I grasp what was going on.

The simple explanation runs along the lines of there being an excess of receivers over payers, combined with balance-sheet issues at the banks and problems in the repo market that make running cash and carry trades nigh on impossible. Let’s face it, with rates as low as they are and spreads as tight as they are, one would have to be mad not to take as much long-dated money as possible.

In one of my incarnations since arriving in the City as an enthusiastic 20-something, I found myself lecturing a number of capital markets-related courses at City University Business School, now known as Cass Business School or simply Cass. There I taught the simple rule that the swap spread roughly reflected the difference in credit quality between the sovereign credit and the generic banking system.

Currencies with negative swap spreads – a rare phenomenon indeed – told the observer everything he or she needed to know about the sovereign. Italy and the lira market were always the prized example, although it was not until after Maastricht and the commencement of convergence that the market for lira swaps became liquid and traded in longer maturities.

Other than markets where generic bank risk or even – in the case of Mexico’s Pemex, for example – where there were corporates that were at a level where the premium for the superior credit risk outweighed the transfer risk, it was as good as axiomatic that swap spreads were positive.

So in the case of the US of A, does the above rule apply? Obviously not. Then why is the banking system priced through the sovereign? The simple reply is sketched out above but that only tells half the story.

Market mechanisms that are as old as mankind itself have been suspended

THE FACT IS the central banks as agents for governments have for the past seven or eight years been poncing about in the financial markets to such an extent that nobody, themselves included, really knows any longer which side is up. The price of short money is artificial. The price of long money is artificial. And, hence, the prices of pretty much all assets, whether physical or financial, are artificial, too. The longer they are and the more they depend on financing, the more artificial they get.

What amazes is the way in which our central bankers are perplexed by the lack of inflation but they miss the simple truth that that market mechanisms that are as old as mankind itself have been suspended at their behest. At the time of the Lehman Brothers collapse, the Federal Reserve’s balance sheet was below US$1trn. In mid-2014, when the “tapering” began, it stood at around US$4.5trn. So far, “tapering” has yielded nothing in terms of balance sheet reduction, as the proceeds of any maturities are still being reinvested – thanks to the Fed itself, the interest income is negligible – and thus the balance sheet footings remain more or less unchanged.

Could it be that we have all spent so long sitting in the hot water now that we have simply become accustomed to the temperature and no longer question what we see?

ONE OF THE victims of the incessant fiddling by the authorities is of course the repo market. In my lectures on the subject, I used to describe repo as being to the bond market what the root ball is to a tree – as complex in structure, largely invisible, a little bit smaller than the visible bit but utterly vital to the life and survival of the tree itself. Regulators have been hacking around and have in the process, to stick with that metaphor, tried to cut the roots off while expecting the tree to survive and prosper.

So much collateral has been sucked out of the markets by the central banks by way of their sundry quantitative easing programmes that the most basic of money-market rates, the repo rate, reflects not the demand for secured cash but the supply of eligible collateral. Thus, despite how and when the monetary policy guys may choose to move reference rates around, the actual and real market may not be in a position to reflect that policy objective.

As we currently stand, it seems as though our lords and masters acknowledge some of the errors of their ways but then tend to choose to try to rectify what isn’t working by creating new rules around the existing ones rather than putting the vehicle in reverse, having a jolly good think and trying again from scratch.

We then end up with layer upon layer upon layer of rules and regulations that eventually reach a level of complexity that leads to the dysfunctional and totally log-jammed systems we are now obliged to live with and, whenever possible, work around.

THE TRADITIONAL SIMULTANEOUS users of all three parts of the equation (long bonds, paying on the swap and funding through the repo) were the major money-centre banks. Their ability to hold asset swap treasury packages was severely curtailed by the financial crisis. Now, there are few market holders of long-dated product and the only big players in the swap market are issuers who are net receivers when they swap their issuance into floating. This means that when spread trades appear with positive carry, there is no-one left to exploit the price mismatch and price them back to normality!

The causes for the inversion of US swap spreads are many and various, but the end effect – semi-annual spreads being negative from the three-year maturity out – tells us that there is something rotten at the very base of money markets and it they’re not working, what chance the rest?

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