Negative swap spreads cannot be a good omen for the financial markets. Interest rate swaps are the most vanilla and widely used over-the-counter derivatives in the world. They are an effective tool in helping institutions hedge interest rate risks. When a company or bank issues floating rate debt but need a fixed rate profile, they can easily swap the floating rate payments to fixed payments. When a pension or insurance company has long duration (10+ year cashflows) and they cannot find any attractive bonds, they can simply buy short cash bonds and overlay long interest rate swaps to hedge away that long interest rate exposure. Interest Rate Swaps are critical components of the derivatives and fixed income markets.
With that as the backdrop, when something looks strange in the interest rate swap markets I tend to pay attention. Back in July of 2009 I asked whether it made sense that 30 year interest rate swaps were trading at an interest level that was below 30 year government bonds. In fact, 30 year swaps spreads have traded as low as -60bps (-.6% to treasuries) and have bounced around the -17bps to -4 bps level for most of 2009 and until recently.
I tried to explain away 30 year swap spreads being negative by suggesting that insurance companies and pension funds utilize swaps most aggressively to hedge their long-dated interest rate exposures because they do not require an outlay of cash and because they closely match the way liabilities are modeled (using the swap curve). I guess you could say that I convinced myself that eventually the abnormality would go away and it was a temporary supply/demand issue in the markets.
Today cannot be explained away. Ten year swap spreads have been positive throughout the crisis and remained so until yesterday. Right now, 10 year swap spreads have plummeted to an all-time low of -8.63bps.
The 10 year part of the interest rate curve is very liquid. Supply/demand issues cannot be the cause of this dislocation. So what does this all really mean?
Interest rate swaps are priced off of the LIBOR (London Inter-Bank Offering Rate) curve which is just a fancy way of saying that this curve represents the level of interest rates that banks and financial institutions of AA ratings quality are willing to lend to each other at. If this is the case, the simple fact that US treasuries are trading at interest rate levels that are higher than swap rates would suggest that the US Government has a credit quality that is lower than the AA rated financial institutions. In fact, it could be argued that the entire universe of financial institutions has moved lower in credit quality and may trade closer on aggregate to A+/AA- which would suggest an even lower credit rating for the government.
I will not make a statement that the US Government is a single A rated entity, but it seems that the alarm bells should be ringing. I hope that this is not a concern over the financial solvency of the government and more of a technical anomaly driven by a glut of treasury supply.