Amazing Move in 30-Year and Swap Spreads
Lars Toomre of Toomre Capital Markets has been actively involved in the credit markets ever since he was moved from the investment banking division to the Lehman Brothers fixed-income trading floor late in 1983. As a result, he has witnessed many the upheavals in the bond markets including the 1986 rally due to $9 per barrel oil, the 1987 stock market crash, the S&L meltdown of 1990, the Asian currency crisis of 1997 and the Long-Term Capital Management ("LCTM") crisis of 1998. During that period, Lars never witnessed a day like Thursday, November 20th 2008.
The bench-mark 30-year Treasury bond is now trading at a yield of 3.43 percent down from 3.95 percent yesterday. This single-day move of 52 basis points and increase of nine points in price rivals the incredible moves in the flight to Treasuries (at the exclusion of all else) during the 1987 crash and the LTCM crisis. Just a week ago on Thursday, November 13th 2008, this same benchmark security was auctioned by the United States Treasury Department and the stop out rate on that auction was 4.30 percent. This particular Treasury bond ended the trading day on Tuesday with a yield of 4.13 percent.
However, as stunning as the rally in the bench-mark 30-year bond has been, the performance of the 30 year swap has been even more impressive. Unbelievably, the 30 year swap rate is now 2.84 percent. Apparently it has dropped approximately 80 basis points on the day and now trades at about 60 basis points rich to the benchmark 30-year Treasury security. Yes, the 30-year swap is now trading almost 60 basis point through Treasuries!!
Remember a swap spread is the yield differential between Treasury bonds and the fixed leg of a fixed-floating interest rate swap. Also, remember that any interest rate swap has to have a bank or other financial institution standing in the middle. With the world excessively concerned over counter-party risk, how is this spread at all-time negative spreads to United States guaranteed Treasury Bonds!?! Why are investors so willing to buy the 30-year swap with all of the attendant long-term credit issues at a lower yield than the underlying 30-year reference Treasury? This implies investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.
To gain a better sense of this stunning 30-year swap move, this swap closed last week at approximately -15 basis points. On Monday of this week, this swap was at approximately -19 basis points. On Tuesday, it closed at approximately -27 basis points and yesterday it closed at -33 basis points. Today it closed at -60 basis points!! Ten basis points in the 30-year Treasury are worth approximately 58 32nds of a point in price (or 1.8125% in price). Since Tuesday's close, the 30-year swap has moved from 3.80% to 2.84% or alternatively has appreciated approximately 17.4% in price!!! Simply amazing!!!
About a month ago, the 30-year swap spread for the first time approached parity with its reference Treasury. The Swap Spreads Turn Negative article from the Financial Times explains, "Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates," said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets. The article continues "For much of this year, the 30-year swap spread averaged between 30 and 55 basis points over the 30-year Treasury yield."
At the time, much of the strange 30-year swap activity was attributed to the esoteric swap desks needing to hedge their positions. Clearly, though, something more is going on to drive this swap to such a negative basis. Apparently, there are many structured product trades buried in trading books all over the world that reference the long end of the Treasury market. Some of these trades were booked years ago. Even if they were booked earlier this year, at say a spread of +40 basis points, the swap payer is approximately 100 basis points under water. The way to stop this bleeding is to buy an off-setting swap where one receives the fixed-coupon, thereby locking in the adverse spread movement.
Toomre Capital Markets LLC ("TCM") suspects that the market participants are now witnessing a classic and massive short-covering rally that is further exacerbated by many dealers approaching their fiscal year-ends and very low levels of liquidity. As one dealer or institutional account throws in the towel and buys the swap to hedge its positions or exposures, it drives the 30-year swap rate even more negative. Such price action in turn causes other participants to likewise throw in the towel. This process will likely only abate when many of the current "short the long end" trades are unwound. In the meantime, expect some truly amazing stories of losses from this dramatic and historic movement in swap rates.