Tuesday, August 17, 2010

Swap Curve Whacked

At a very basic level, interest rate swaps allow the exchange of a fixed rate for a floating rate across maturities. When viewed in the form of a swap curve (below), we can see what the market is pricing in for this fixed for floating across maturities, similar to a Treasury curve (i.e. the level in which you can get paid over various maturities on one side, while paying 3-month LIBOR on the other).

Below we see the swap curve at spot (i.e. current levels) and what the market is pricing in one, three, five, and ten years into the future.

What is the below chart showing?

1) The swap curve is currently steep, though not as steep as the Treasury curve (as long swaps are currently trading well through Treasuries)
2) The market is pricing in rates to rise rather dramatically at the front-end of the yield curve over the next five to ten years (though not much at all over the next 12 months)
3) The yield curve is actually inverted at the very long-end as early as three years out

Why? For one, investors that were underweight (or short) duration got themselves caught majorly off-guard over the course of the past few weeks as the long-end has taken a cliff-dive and now need duration at any cost.

Source: Bloomberg