Spread 'em

If something seems to good to be true, it usually is.   So it was with the set up in Treasury bonds yesterday, as they delivered a tasty squeeze- but only after early Gilt market weakness sucked in more sellers of UK bonds before reversing and reminding punters that selling intraday weakness in fixed income has been a sucker's game for a long, long time.

Today of course sees the release of UK CPI for September, a month which saw sterling start near its post-Brexit vote highs and end near its (pre flash crash) lows.  It seems virtually axiomatic that inflation is going higher in Britain, beyond the symbolism of he lowly tub of Marmite.  The forecast is for a mere 0.1% monthly rise, which seems modest; that being said, if it comes in as expected a further bout of short covering in Gilts may well ensue.  That will be the price action you want to sell into.

Back in the US, per yesterday's post curve steepeners are all the rage.   It's not hard to see why; beyond the steepening rhetoric from Rosengren and the softly-softly comments from Yellen and Fischer, the chart has not only shown signs of life in the last couple of months...

...but also remains at very attractive levels from a more strategic perspective.


Then again, if we like steepeners in bonds at 127 bps, we must love them in swaps at a mere 69 bps!  Moreover, unlike the Treasury curve, the 5/30 curve in swaps is still flatter than its lowest point in 2015.   What's going on here?


The answer, of course, is swap spreads, most notably at the back end of the curve.   30 year swap spreads are plumbing uncharted depths, reaching -56 bps yesterday, an all time low.

Here's the chart of the last year...

...and here's what it looks like from a longer term perspective.

It is a measure of the perversity inflicted upon financial market pricing by regulatory and monetary policies that there are a number of valid reasons why spreads are negative:

* Many holders of Treasuries have historically lent them out in the repo market as collateral for short term monetary loans- which, in the case of leveraged buyers of Treasuries, are used to pay for the bonds in the first place.  However, the repo business is balance sheet intensive for banks and generates a fairly paltry return in compensation.   In the new regime, banks are simply not interested in using their balance sheet to help clients buy bonds, which has decreased the potential buying power of Treasuries.

* Historically, the spread between LIBOR and the GC repo rate has been a good proxy for swap spreads.   Although it's declined a bit recently, as you can see it's nowhere near the post-crisis lows like swap spreads are.   In this case, regulation is also having an impact, via the much-discussed change to money fund regulation (which went into effect last week) that has pushed LIBOR higher.  Last year, however, there was briefly a time when LIBOR (uncollateralized lending between banks) was lower than GC repo (lending with Treasury collateral.)  Taken at face value, this implies that a bank could get a lower rate by calling a competitor and asking for a 3 month loan with no strings attached than if he offered to post Treasury bonds as collateral.  To paraphrase Inigo Montoya, I do not think these rates mean what you think they mean.


* Reserve managers are selling Treasuries.  This remains an ongoing consequence of dollar strength, and while it may explain some of the recent decline in swap spreads it certainly doesn't explain the level; 30 year spreads were negative even when CBs remained enthusiastic buyers of Treasury bonds.

*  Swaps are less risky than was historically the case.   Until a couple of years ago, swaps were a bilateral agreement between two consenting parties, which created counterparty risk.  This was obviously a major feature of the spread widening in 1998 (LTCM) and 2008 (Lehman) when notable counterparties in the swap market went bust.  With the move to central clearing and an exchange as a counterparty, this bilateral credit risk has been largely mitigated for vanilla swaps, so it does kind of make sense that they should be seen as less risky relative to Treasuries than was historically the case.   It still doesn't mean they should be less risky in an absolute sense of course.

* Corporate issuance.   It's been well documented that corporate issuance volumes in the stratosphere.  When a corporate issues a bond, they undertake to pay a fixed coupon.  With an upward sloping yield curve, it makes sense to swap this into floating rate obligations to reduce interest cost.   Thus, when corporates issue debt (which they have done in record volumes), they hedge by receiving swaps.  On top of the other factors mentioned above, this has created something of a one-way street in terms of the demand to receive swaps relative to owning Treasuries...hence the decline in swap spreads.

While some of these factors are structural, others are more cyclical, and thus more apt to reverse in a timely fashion.  Who knows what the Platonic ideal of the "correct" value for long dated swap spreads might be, but at all time lows it seems a reasonable proposition that it is somewhere north of here.


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abee crombie
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October 18, 2016 at 7:36 AM ×

Nice post MM. The move in longer term rates has the potential to be a game changer here, with risk parity funds about to get screwed. Imo, ignore this at your own peril.

Though for equities its still earnings season with the all important tech sector still 2 weeks away from most finishing . Weve seen in the past the market get bearish ahead of them only to get blown out by good results. Keep that in mind.

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abee crombie
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October 18, 2016 at 7:36 AM ×

Nice post MM. The move in longer term rates has the potential to be a game changer here, with risk parity funds about to get screwed. Imo, ignore this at your own peril.

Though for equities its still earnings season with the all important tech sector still 2 weeks away from most finishing . Weve seen in the past the market get bearish ahead of them only to get blown out by good results. Keep that in mind.

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Anonymous
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October 18, 2016 at 8:01 AM ×

The Z-spread on Treasuries is odd but look at this relative to Gilts and Bunds and you get an even stranger picture.

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checkmate
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October 18, 2016 at 8:41 AM ×

Good post on the gilts. Think it will take a loose stop to stay the ride ,because we know periodically the mouthpieces are going to come out and say XYZ and the nervous types are going to cover.
Purely technical trade for an initial position long on Capita to test if selling is exhausted.

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October 18, 2016 at 10:13 AM ×

Do you want cheapest senior bank credit, low cash price, CMS 30-2 US with a floor??
Here's my present for you

XS0461332933, 155mln size issue, DB Float 15/04/2025 in dollar, 2.8 until 2018 then 1.65*CMS 30/2 collared, floored at 1.5. Cash price about 83, make your calculus and watch the spread...

it's just an example, but this type of CMS structure are a big buy for me...

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JMT
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October 18, 2016 at 2:12 PM ×

Great post MM on long end swap spreads. USSP30 really is quite the conundrum!
I completely agree that at -56 it is an opportunity, but having been burned before fighting this, it is a trade that needs strong discipline and strong conviction to withstand the potential volatility. The positive carry is overwhelmed by the DV01 risk, and its illiquidity (appearing to trade by appointment) has it prone to 'gap'. As the chart shows, this spread has never really recovered from the events around Lehman where RV accounts were blown out and bank balance sheet risks curtailed.

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CCMM
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October 18, 2016 at 4:53 PM ×

Re: repo rates.

I'd say banks are unwilling to intermediate repo trades on balance sheet. However, a big theme since ~2011 has been quality collateral shortage, which has pushed down GC repo rates as banks struggle to reverse in enough govies into their liquidity buffers (in lieu of cash). The effect is particularly acute at quarter- and year-end.

I'm told that swaps are collateralised series of of 3-month credit risk, plausibly lower risk than 30y govt. Also receiving in the long end by corporates feels like a bigger driver than GC.

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johno
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October 18, 2016 at 5:29 PM ×

Thank you for the interesting post, MM. And nicely done on your AUDNZD exit the other day.

5s/30s is curious here. JPM argues it's 20bps too steep on their model, which is a regression on 2y3m OIS, 5y5y inflation swap rates, and VA insurance hedging needs. Seen that way, it's at the wides of the last 5 years. Will be interesting to see whether we get a regime change ... plausible if inflation picks up and Yellen runs hot/does optimal control, and/or if a party sweeps the executive and congress and boosts fiscal spending (electronic markets have Democrats at only 20%-ish odds of that).


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Mr. T
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October 18, 2016 at 5:51 PM ×

Anyone else wondering why "running hot" in shelter (+3.4%) and medical (+5.2%) is a good thing? If I understand the thinking correctly, a modest but positive inflation assumption will drive consumption via the "cheaper today than tomorrow" paradigm. Fine, and I agree it applies to discretionary purchases, but I'm not about to stock up on hep-c treatments or extra places to live in anticipation of higher prices. I do wish the FOMC spoke about inflation with a little more nuance. If Clinton is elected and pushes through drug pricing reform (or CA prop-61 etc) - is that bad policy because lowering drug costs will bring inflation down?

With my recent fairly neutral and flat positioning I'm finding it harder than expected to generate conviction about most anything.

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Anonymous
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October 18, 2016 at 7:38 PM ×

Well, the impact on drug companies are pretty much priced in. And it all depends on who control house right now, given that Dem will take WH and senate.

And on CA prop-61, it looks like that the opposition has some legitimate concerns but it is going to pass anyway.

And another thing on this election, the most recent wiki leak on HRC suggested that she actually likes oil/gas more than we think (and dislike extreme environmental groups, see FT article). This should be slightly bullish to oil/gas stocks and would be interesting to see if any opportunity would emerge.

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12yo HFM
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October 18, 2016 at 8:05 PM ×

So maybe rally after (or right before) elections, making 12yo HFM richer?
Already happening bruh, our JP/EU equity positions up hundreds of bps today. Lit af.

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washedup
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October 18, 2016 at 9:16 PM ×

T/Anon 7:38 - of course she 'likes' oil and gas, as in she 'used to' before all her dirty linen was publicly displayed. I will reiterate what I said a few days ago - this idea that HRC will be a chump for corporate interests and wall street is a massive blind spot. She will have one job from day 1 of assuming office, and that would be to get re-elected - this, after she just went through a bruising campaign where she was harangued for kowtowing to aforementioned interests and with 50% of the country thinking she is a criminal - the idea that she will do a public high five with the 'elites' immediately after taking office, or even the suggestion of underhand deals in this new age of hacking, goes against everything I know about opportunistic politicians (Theresa May post Brexit, anyone?)

As for the economy, goldilocks is over - best case is continued slow growth but with higher inflation, which will further corrode the credibility of the powers to be because of effects on housing and healthcare. Impact on equities unclear to me - impact on bonds clearer.

T - the expectations theory obviously doesn't apply to things where (for most americans) your employer deducts them from your paycheck, so no one cares - that being said, how about pricing power for big pharma going forward? don't see how anything that comes in the future could be as sweet at obamacare for them - they are still up 100% from 2010-2011 lets not forget.

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Anonymous
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October 19, 2016 at 12:33 AM ×

If you think about all the regulatory capital required to put on a long end spread widener, suddenly the carry doesn't seem so attractive.. USD swap spreads are a prime example of regulation gone haywire.

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