Swap spreads have become a hot topic lately and rightfully so. Swap spreads have tightened so aggressively they have defied expectations and some would say logic. Almost the entire swap spread curve (except the 2 & 3yr) is trading negative (swap yields below equivalent Treasury yields).
Prior to the financial crisis in 2008, swap spreads were always positive because swaps represented a measure of credit and liquidity risk over Treasuries. In 2008, the market volatility created huge demand for duration and 30-year swaps were the most effective and liquid way to satisfy this need. So, for the last 5 years, 30-year swap spreads traded negative on this efficiency premium. Rarely did other maturities trade negative, until now. There are several structural and technical factors which are influencing supply and demand dynamics within the swaps market which is directly resulting in negative spreads.
The rates market as a whole is and has been undergoing changes which are limiting the natural sellers of swaps and tightening spreads:
Recent technical factors have exacerbated the moves:
The combination of structural and technical factors are creating a swaps market that is decidedly one-sided (only buyers) and a Treasury market that is capacity constrained, creating a dislocated and tighter swap spread market. The structural issues are likely to persist and result in fewer natural sellers of swaps and lower swap spreads. The shorter-term technicals should dissipate as the imbalance corrects resulting in fewer maturities with negative spreads. While the tightening of spreads has benefited certain fixed income asset classes, the efficacy of a diminishing swaps market is being questioned. There is a troubling disconnect, when regulation penalizes certain functional activities and distorts the informational content communicated by markets. The recent dislocation in spreads is a continuation of market breakdowns investors have experienced over the past two years. Hopefully, the stresses we are seeing in the various rates markets are the tail end of a longer adjustment period to the new regulatory regime. Unfortunately the cracks in market functionality are appearing more frequently than most had expected.