Swap Spreads Out of Whack

Warning: this WILL be boring to someone not involved in the fixed income market, yet it is an important lesson that we should not expect anything "normal" in this given environment...

Swap spreads are MASSIVELY wider on the front end of the yield curve (specifically the two year) than the back (the thirty year). This is odd. As Accrued Interest explains:

To translate... swap spreads is the yield differential between Treasury bonds and the fixed leg of a fixed-floating interest rate swap. Remember that any interest rate swap has to have a bank or other financial institution standing in the middle. With the world scared out of their minds over counter-party risk, how is this spread at all-time tights!?! By comparison, 2-year swaps have a spread of 104bps, and traded as high as 165bps earlier this month.

Things are far from normal. Why specifically? Lets go to Across the Curve:

The tightening in the 30 year spread has been driven by pension fund receiving and exotic derivative desk management of positions predicated on the assumption that the 10year/30 year swap rate (not spread ) curve could not flatten to this extent. Desks are short the 30 year sector and position management has them receiving to hedge exposure.

The problem is that one round of receiving begets another which begets another. So the price action in the long end of the swaps curve may produce some relationships which seem unwarranted but are motivated by the urge to survive and trade one more day.

The common trade was to bet that this type of event would never happen. Now that it is 100+ bps out of line, those investors looking for incremental income are forced to sell out of the positions (margin calls), even though this is the BEST time to keep the original trade. Yet another item to keep track of that should revert when things are back to "normal". Back to Accrued Interest...

This just reiterates what I said the other day about leverage. The market can't act "normal" when fresh capital is hard to come by. You should still buy bonds based on fundamentals, but bear in mind that it may take a while for fundamental analysis to pay off.