Why Have Swap Spreads Turned Negative?

Interest rate swap spreads, a specialized metric within financial markets, have traditionally served as a barometer of underlying economic conditions and market sentiment. These spreads offer insights into perceptions of credit risk and liquidity across various financial instruments. Historically, these spreads were consistently positive, reflecting a conventional hierarchy of risk and return. However, in an unusual development, swap spreads have turned negative, presenting a counterintuitive shift that challenges established financial theories. This phenomenon signals a departure from historical norms.

Understanding Swap Spreads

A swap spread represents the difference between the fixed interest rate of an interest rate swap and the yield of a government bond with a comparable maturity. For instance, in the United States, this typically involves comparing the fixed rate of a U.S. dollar-denominated interest rate swap to the yield of a U.S. Treasury security of the same tenor. Interest rate swaps are derivative contracts where two parties agree to exchange future interest payments, usually one fixed and one floating rate, over a specified period. The fixed rate on these swaps is influenced by market expectations of future interest rates, along with factors like counterparty credit risk and market liquidity.

Government bonds, such as U.S. Treasuries, are generally considered to be among the safest and most liquid assets globally, often serving as a benchmark for “risk-free” rates. Traditionally, the fixed rate of an interest rate swap would be higher than the yield on a comparable government bond. This positive spread compensated swap counterparties for the perceived credit risk embedded in the swap arrangement and for any liquidity premium associated with holding a less liquid asset than a government bond.

The Phenomenon of Negative Swap Spreads

For many years, the expectation was that swap spreads would remain positive, given the inherent credit risk in a swap transaction compared to the perceived risk-free nature of government bonds. However, this conventional understanding began to unravel after the 2008 global financial crisis. The 30-year U.S. dollar swap spread became negative then, and the 10-year spread followed suit years later.

A negative swap spread means that the fixed rate paid on an interest rate swap is lower than the yield on a U.S. Treasury bond of the same maturity. This situation is counterintuitive because it implies that, in certain circumstances, the market perceives U.S. government debt as carrying a higher effective yield than a swap, even though swaps typically involve some level of counterparty credit risk. This inversion challenges the fundamental idea that government bonds, being nearly risk-free, should always yield less than other financial instruments of similar duration.

Factors Driving Negative Swap Spreads

Treasury Scarcity and Repo Market Dynamics

A significant factor contributing to negative swap spreads is the heightened demand for U.S. Treasury securities, leading to their scarcity in the market. Treasuries are highly sought after by various market participants for their safety and liquidity, especially in times of economic uncertainty. This demand is particularly pronounced in the repurchase (repo) market, where participants lend and borrow cash against collateral, often U.S. government bonds. The strong demand for Treasuries in the repo market can drive down their yields, as investors are willing to accept lower returns for the safety and ease of use these assets provide.

Treasuries can trade at a “special” rate in the repo market, meaning they are so desirable as collateral that their repo rate falls below the general funding rate. This “specialness” implies that it is cheaper to borrow cash against Treasuries than against other forms of collateral, effectively boosting their value and reducing their yield relative to other instruments. This increased demand for Treasuries pushes their yields lower, which in turn compresses swap spreads. The reduced yield on Treasuries means that the fixed rate of a swap, even if it incorporates some credit risk, can fall below the Treasury yield, resulting in a negative spread.

Central Bank Actions (Quantitative Easing/Tightening)

Central bank monetary policies, particularly large-scale asset purchase programs known as Quantitative Easing (QE), have played a substantial role in influencing swap spreads. During QE, central banks purchase vast quantities of government bonds from the market, aiming to inject liquidity, lower long-term interest rates, and stimulate economic activity. These purchases effectively reduce the supply of available Treasuries in the market, increasing their scarcity and driving down their yields. This artificial suppression of Treasury yields contributes directly to the narrowing and eventual negativity of swap spreads.

Conversely, Quantitative Tightening (QT), where central banks reduce their bond holdings, can also impact swap spreads. By allowing purchased bonds to mature without reinvestment or actively selling them, QT increases the supply of Treasuries in the market. This can lead to higher Treasury yields as the market absorbs more supply, potentially narrowing negative swap spreads or pushing them back towards positive territory.

Bank Regulatory Frameworks

Post-financial crisis regulatory reforms have significantly altered banks’ balance sheet management and their willingness to engage in certain market activities, thereby impacting swap spreads. Regulations such as Basel III, particularly the Supplementary Leverage Ratio (SLR), require banks to hold a certain amount of capital against their total leverage exposure, which includes both on-balance sheet assets like Treasuries and certain off-balance sheet items. This framework aims to make the banking system safer by increasing capital requirements.

However, it also makes it more costly for banks to hold large inventories of assets, including low-margin U.S. Treasuries. The SLR treats all assets, regardless of their risk, similarly for leverage calculation purposes. This can disincentivize banks from holding large amounts of Treasuries, even though they are considered safe, because doing so consumes valuable balance sheet capacity that could be used for more profitable activities.

As a result, banks become less willing to act as intermediaries in arbitrage trades that would traditionally push swap spreads back to positive territory. This reduced capacity and incentive for banks to arbitrage the spread leaves the market susceptible to other forces that can drive the spread into negative territory.

Broader Market Significance

For corporations and financial institutions, negative spreads can increase the cost of hedging interest rate risk. When the fixed rate on a swap is lower than a comparable Treasury yield, the cost of entering into interest rate swaps to convert floating-rate liabilities to fixed-rate ones, or vice versa, can become less favorable. This can influence how companies manage their debt and exposure to interest rate fluctuations.

Negative swap spreads can also signal reduced liquidity in both the Treasury and swap markets. When market intermediaries face higher costs or regulatory constraints, their capacity to facilitate trades and provide liquidity diminishes. This can lead to wider bid-ask spreads and greater difficulty in executing large transactions without impacting market prices. Such conditions may indicate underlying structural issues in financial markets, rather than solely reflecting economic fundamentals.

They can reflect strong investor demand for the safety and liquidity of government bonds, even at compressed yields. This flight to safety might be driven by concerns about broader financial system health or perceived risks in other asset classes. For investors, persistent negative swap spreads suggest that traditional arbitrage opportunities between Treasuries and swaps may be limited, requiring adjustments to investment strategies and portfolio construction.

Central banks monitor swap spreads as an indicator of market functioning and the effectiveness of their policies. A sustained negative spread can highlight the unintended consequences of quantitative easing or regulatory frameworks, prompting policymakers to evaluate their impact on market structure and liquidity. Understanding these dynamics is crucial for central banks to ensure financial stability and the smooth transmission of monetary policy.