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Strategies & Market Trends : John Pitera's Market Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: John Pitera who wrote (17341)	11/16/2015 11:12:22 AM
From: John Pitera	1 Recommendation Recommended By mary-ally-smith Respond to of 33421

Why are swap rates below bond yields? Michael Mackenzie and Joe Rennison November 10, 2015 11:25 am US interest rate swaps, popular derivatives that track government bond yields, have experienced a spectacular collapse this month with an array of reasons being suggested by traders. This market emerged during the 1980s and has become a fundamental part of finance. Like bonds sold by companies, swap rates have historically traded at a premium over Treasury yields — seen as the risk-free rate for pricing other types of debt and derivatives. Now dealers and users of US swaps, such as hedge funds, asset managers and companies, are watching the swap rate relationship to underlying Treasury yields, known as a spread, become increasingly negative. Last week, the 10-year swap rate at one stage was quoted 18 basis points below the 10-year Treasury yield. The current swap rate of 2.225 per cent trails that of the Treasury benchmark’s yield of 2.33 per cent by 10.5 basis points. Why is a negative relationship prevailing? Analysts at Deutsche Bank say the recent swap spread tightening *reflects “tighter macro prudential regulation, higher capital requirements and reduced dealer balance sheet capacity”.* Also playing a role is swapping activity from companies selling debt. Companies and institutional investors exchange floating rates of interest for fixed rates via a swap contract. When a company sells fixed-rate debt, it can use a swap to offset the payment of a bond coupon and pay a much lower floating rate — three-month Libor. Such activity pushes swap spreads lower and has occurred when dealers have been swamped by sales of Treasury bonds from central banks and other investors. The combination of *hefty company debt sales being swapped and higher dealer inventories* of Treasury debt, helps explain why swap spreads are negative. How serious is the current dislocation between swaps and bonds? Some say swaps are a broken market and the most visible example of post-2008 regulation of the banking system that entails serious consequences for investors, banks, companies and even the US taxpayer. The bigger implication is that the cost of funding US government deficits in the coming years, which are projected to climb sharply, may well be higher due to a tougher regulatory environment for banks that underwrite Treasury debt sales. Deutsche’s regression analysis places a fair value of around 3 basis points for the 10-year swap rate over the underlying 10-year Treasury yield. It thinks “the days of positive double-digit spreads, and perhaps positive spreads full stop, could be behind us”. And with year end and a Federal Reserve interest rate rise approaching, higher volatility looms for the swaps market. Last week’s moves represented some of the biggest daily shifts since the financial crisis. How long can swap rates trade negative to Treasury yields? Under normal market conditions the current inversion should be swiftly reversed, but thanks to tougher bank capital regulation, derivatives trading appears to have entered a new era. Currently, no one appears willing to normalise the relationship between swap rates and Treasury yields. “For a trader, trying to pick the bottom offers a different risk/reward in today’s heavily scrutinised world, so we haven’t seen the type of aggressive buyers that we used to see when valuations move to extremes,” says Michael Cloherty, head of US rates strategy at Royal Bank of Canada. Trading Treasuries and swaps relies on funding via the repurchase or repo market. Thanks to balance sheet constraints, the use of repo by dealers is shrinking, another factor sustaining negative swap spreads. “As capital and balance sheet have become more scarce commodities, banks have responded by reducing the size of their repo books due to heavy balance sheet consumption and relatively low margins of the business,” says Deutsche. That means hedge funds, which in the past would reverse any inversion, cannot rely on the repo market to buy US Treasuries and pay the fixed rate on a swap. For a bank, facilitating a repo trade on behalf of a hedge fund means having it sit on its balance sheet, consuming precious capital.

To: John Pitera who wrote (17341)	11/16/2015 11:48:09 AM
From: The Ox	3 Recommendations Recommended By isopatch John Pitera sixty2nds Read Replies (2) \| Respond to of 33421

Money managers are dealing with an enormous amount of uncertainty about the future. Many traditional metrics aren't nearly as reliable (or outright fail) within this environment and plenty of questions can be raised whenever conclusions are being formed based on these same metrics. Starting with ZIRP or, more dramatically, negative interest rates, much more caution (or hedging, if you wish) is being used. As more "hedges" are seen as "viable investment or trading vehicles", larger problems surface. Instead of more patience, we seem to be observing more "restlessness". Chasing yield or ever grater returns on investment will likely cause poor investment decisions. Steady, 12% gains per year (basically) double your investment money in 5 years. Too often, people lose sight of simple issues like this.