Thursday, January 25, 2018

This Might Be Important: "Today’s topic will once again involve swap spreads".

From The Macro Tourist:
Today’s topic will once again involve swap spreads. I am admitting this fact up front in the hopes of convincing you to read on. I know many readers find this obscure part of the institutional fixed income market complicated, and more often than not, boring. I get it. It’s not nearly as exciting as reading about strapping on some S&P 500 risk, or selling VIX, or god-help-you, buying the latest ICO offering. But I firmly believe that negative swap spreads were an anomaly from the 2008 Great Financial Crisis, and monitoring their return to “normal” levels offers some important clues as to the development of the economic recovery. It is an important indicator that many strategists are missing.

I have long been banging on the table that shorting swaps was a better way to position a portfolio for rising long term yields - A Better Way to Short the Bond Market? I don’t want to repeat the same argument again, but let’s have a quick recap. When the Great Financial Crisis hit, most market participants would have assumed that swap spreads would have exploded higher, much like they did during the Long-Term-Capital-Crisis. In the past, worries about credit risk from the banks that issue swaps meant that investors bid up the price of risk-free US Treasuries, sending the spread soaring higher.
In the initial days of the Great Financial Crisis, US swap spreads did in fact start to widen. But then, much to almost everyone’s surprise, swap spreads collapsed below zero. It made no sense. Why would investors ever enter into a swap arrangement with a bank that has credit risk instead of just buying US Treasuries? Especially in those days when no one trusted the financial soundness of banks.

Well, the answer was that it had more to do with financial system’s plumbing than a logical decision by markets. And the next time some newly-graduated-business-school-keener lectures you about Professor Malkiel’s market efficiency theories, just show them the chart of the US 30-year swap spreads and ask them to explain it.
Swap spreads dove because the supply of bank balance sheet was dramatically curtailed. Basically, banks, faced with more regulations and increased capital requirements, withdrew their participation in the swap market. The demand for swaps fell but not as quickly as the supply. The end result was that this mismatch of demand-supply meant that the previously unthinkable occurred, and swap spreads went negative. What would have usually been arbitraged away by proprietary trading desks at banks and other financial institutions was left to persist for years.

And this strange condition was symptomatic of a bigger problem. After witnessing some truly asinine moves by the likes of Dick Fuld’s Lehman or the myriad of other banksters, governments and regulators were eager to make sure it did not happen again on their watch. So they clamped down on both credit and leverage.

Therefore it is no surprise that banks withdrew from extending their balance sheet for swap trading. With higher capital requirements and more scrutiny from regulators, most banks made the decision it wasn’t worth it.

This might have been fine if it was only swaps that banks abandoned. However, the sad truth was that this phenomenon occurred over many different business lines....MUCH MORE