swap spreads

Im no expert in these, and have never traded them. But I notice today that 30yr swap spreads are trading at -35. How does that make any sense? Why does a government bond yield more than a swap at a bank during a banking crisis?

I second this question. Sorry I can’t assist chicagofx but I was confused by Rick Santelli’s comments this morning on CNBC…where did you see this swap spread at? I only heard it this morning from CNBC

It doesn’t make sense and I don’t have a complete explanation. Apparently, it’s about hedging derivatives contracts. I think this has to do with the demand for dollar-based funding so there are lots of currency swaps out there with interest risk being hedged in interest rate swaps. It’s a weird side effect of the credit debacle.

its bc of exotic desks out there hedging due to the flattening of the 10 x 30 swap curve. as the curve flattened they needed duration and began to receive in 30-year swap spreads. as they did this it put downward pressure on the 30yr point of the spread curve, flattening 10’s 30’s even more. which forces them to continue to receive(thus pushing spreads down even further). the 10’s 30’s swaps curve actually inverted today. there are also lots of natural receivers out there in 30’s as weak balance sheets are preventing the purchase of treasuries for asset liability matching so people receive on 30-yr swaps.

is this what is driving down 10s 30s treasury yields? (arb guys)

shames plug for acrossthecurve.com (actually its a good commentary site for fixed income) “There are several factors motivating the significant compression which the yield curve has undergone since the completion of the refunding process. The completion of that process is one of the key factors as the weight of the long end supplies pressured spreads wider as dealers made room for new supply. Conversely, the Treasury will announce 2 year and 5 year supply today. Prognosticators are forecasting $35 billion 2 year notes and $25 billion 5 year notes. As we approach month end index extension becomes a factor in the flattening trade and that out performance of the long end. In months in which there is a new long bond (as this one) the index usually has a greater than normal extension. There is probably some buying in advance of that. Pension funds and money managers have engaged in a duration grab. That flow has not abated.”

thanks for the response - yeah I did some digging and the 10s/30s inversion notes was what I found too, along with the increased issuance story and also that people who had swaps on with Lehman suddenly had to reestablish the positions that they suddenly didnt have. The 10/30 inversion notes sound the most plausible to me. Spectacular move, wish was there was a way of buying call options on it, at some point itll snap back but I dont want to jump in front of the train…

negative 51 1/4 at the moment.

Look at that long bond go!

its the deflation trade. check out japanese LTGB yields. still a long way to go for USTs. with the bailout caution in congress, supply concerns are also subsiding??

What’s the general interpretation for swap spreads? Usually just the riskiness of corporate vs treasuries of the same maturity, yes? I was reading on Macro Man who was comparing the 2 year swap spread to the 30 year swap spread (by subtracting the 30y from the 2y). He was going on about how it is unusual and defies belief. But what financial or economic concept does subtracting these capture. He says something like how near term credit is less desirable than long term credit. This does seem odd, since if you don’t trust a company in the short term, why would you be more confident in the long term… I guess that is what is meant by a liquidity crisis as opposed to a true business crisis - and maybe the idea is that long term is less affected because every debtor is going to get a bailout at some point - either through government handout or through inflation (or both).

I don’t think he’s right even on a credit basis. It’s not uncommon in the CDS market to have a term structure that is hump-shaped (higher default probability in early years than later years). Why should that be belief-defying in the swaps market?

That’s why I was asking… I’m not sure how to interpret the shape and what would be usual vs unusual. Glad to hear that I’m not the only one that is not sure what’s to be concerned about here. (but really, I’d just like to know what people are trying to figure out when they look at the curve).

I do think that a negative spread is pretty wacky and no matter how many explanations you can give of it, it’s a sign of something very unhealthy going on.

some market commentary we have seen heavy receiving from insurance companies and real money who are faced with significantly lower assets and have seen the duration of their CMBS positions shorten dramatically as dollar prices have fallen over 40% in two weeks. We know that pension funds are underfunded and need long dated assets and that structured desks need to receiving the long end both as the curve inverts and the yen appreciates. option desks are short significant amount of low strike receivers on 20y and 30y tails from the pension fund risk reversal trade (starting in 2003 when pension funds first started to become underfunded and the longer dated forwards were around 6% they went on huge programs in which they gave up their upside- sold 7% payers (+100 bp) since 7% was greater then their liabilities to buy 5% (-100 bp) receivers to lever up in a low rate enviornment). Since that time they have consistantly been rolling out their low strikes, leaving dealers short gamma and vega on the long end. given that the rates came into the week already at historic lows they have been reluctant to cover their shorts as those rates moved 150 bp, resulting in a capitulation yesterday. In my commentary on Monday i stated all of the reasons why the market was too cheap and that a few different ways to get long the belly of the curve. While those reasons are all still valid, at this level in rates it just doesnt make sense for insurance companies or pension funds to receive the market as their liabilities are higher then 3% and they would just be locking in losses. It seems to many are now in the market cant sell off camp which makes us very succeptable to a big flush out on any news by the fed/treasury/gov’t…… and oh i should add that gamma was up another 8 bp vol (1m10y is now 212 bp vol) and vega another 4 bp vol as dealers and agencies are short from the contraction of their bermuda books.

I can’t paste the graphs, but this was from a UBS market commentary e-mail on Monday. “Exotics Hedging and Swap Spreads: Why 10y Spreads Have Tightened The market has been watching with shock and awe at the on-again off-again inversion of 30y swap spreads to Treasuries. The shock and awe of course comes from the power of the hedging needs of exotics desks. The hedging needs of exotics desks look powerful enough to run over just about anything that gets in their way. We have written previously about the impact of exotics hedging from non-inversion notes on the 10s30s swap curve (see “Recent Moves in Swap Spread and Curve Inversion” from October 9). In this update, we add the exotics hedging from Power Reverse Dual Currency notes (PRDCs). These are 30y Libor swap-based structures that allow Japanese investors to enjoy the higher yield of the USD Libor curve, but take the cash flows in Japanese yen. The hedging needs of exotics desks are such that when the yen gets stronger, exotics desks need to receive in 30y USD swaps. The graph below shows the relationship between the yen on the x-axis and 30y swap spreads on the y-axis at 15-minute intervals from the morning of October 8 to Friday November 14. The main observation the graph highlights is that when the yen is weaker than (that is, above) 97 or so, there has been a strong linear relationship between spreads and the strength of the yen. However as the yen strengthens past 97 this relationship starts to break down. There are two contributing factors to this. First, the hedging needs are based on the fact that as the yen strengthens, the PDRC note declines in value and becomes less likely to be called. This lengthens the duration of the note and hence exotics desks (who issued the note) must receive on 30y USD swaps. At some point, the amount of duration adjustment necessary lessens as the option to call the note goes far out of the money. On the other side, hedge funds and other speculators may feel that once the spread goes negative, the pricing of the market is irrational enough that they begin to enter spread widening positions. If we look at a longer range history of this relationship, it is clear that something changed on October 8. In the graph below, we look at daily closes back to the beginning of July 2007. Prior to October 8, there was a fairly tight relationship between 30y spreads and the strength of the yen. What happened on October 8 is that the Treasury made a surprise announcement of the reopening of old 10y issues. The consequent weakening of the 10y sector may have helped the 10s30s swap curve to invert. As we discuss in our previous note, this triggered runaway negative gamma hedging in the 10s30s swap curve. As the 10s30s swap curve inverts, the non-inversion notes issued by exotics desk require hedges that further invert the curve. After October 8, a different hedging dynamic began, as we show in the intraday chart above. In a weird turn of events, this hedging dynamic through the two types of exotics hedging and the strengthening of the yen has impacted 10y spreads as well. In order to illustrate the interconnection between the two types of exotics hedging, we show below an hourly history of the yen, 10y and 30y swap spreads and the 10s30s swap curve. The chart above is somewhat complicated, but we can see definite periods where each type of exotic hedging dominated. For example, on October 8, the Treasury announced the reopenings of the old 10y notes to fix the repo fails problem. This immediately cheapened the 10y sector, both Treasuries and swaps (10y spreads hardly moved) and inverted the 10s30s swap curve. As the yen traded in a range, the 10s30s hedging dominated. 30y spreads were briefly brought into negative territory. Once 10s30s disinverted, on October 21 the yen started to strengthen. This starts a dual dynamic in exotics hedging. 1) The yen strengthened and PDRC hedgers received in 30y USD swaps 2) With the 10s30s in positive territory, non-inversion note hedgers put on steepeners to counteract the flattening from 1). With the 10s30s in positive territory, the pressure then fell on 10y spreads, and they tightened. In fact, this has happened on two other occasions when the yen strengthened, the 10s30s was in positive territory and 30y swap spreads were close to zero. We have circled all three periods in the graph above. The net effect is that in each case there was pressure applied to 10y swap spreads. Around October 24, we see a big move strengthening move in the yen, but 30y spreads do not move as much and seem to be pinned at zero. We see this as evidence that speculators would step in anytime that 30y spreads went negative to put on 30y spread widener trades. In any case, the 30y spread market continues to be dominated by exotics hedging desks needs with some effects into 10y spreads. Our advice… get out of the way or get run over.”

there’s nothing wrong with a humped spread curve, but the swap curve lower than the UST at 30 yrs is the wierd thing. something similar is actually happening in india right now - the swap curve on the rupee is below the gilt curve for nearly the entire short-intermediate maturity (they don’t have LT swaps on the rupee i think). the smart commentary on this is that the swap markets are faster to react to market expectations (not sure i understand why), so often lead the gilts. something about the gilt market being a delivery market, and the swap markets having many more speculators and traders since its a cash settled market. and indeed there too, the LT gilts have followed the swap curve down. chadwick - think of default probability in terms of specific periods (0,1,2 etc). you can then bootstrap a spread spot curve over the spot curve. the spread yield curve over the yield curve is a cumulative probability concept (0-1, 0-2, 0-3, etc.). if the near periods have higher default probability than the farther periods, the spread yield curve will be humped/inverted.