Capital markets: Swap spreads signal market failure
Negative swap spreads are more than a sign of dysfunction in the interest-rate derivatives market. They are the result of fundamental changes in the structure of the capital markets that have been forced by post-crisis banking regulation.
On October 23, 2008, something strange happened in the swaps market. Given that Lehman had filed for bankruptcy only a month before it was only one of many unthinkable events taking place, but on that day the 30-year swap rate traded below the 30-year treasury rate for the first time. This shouldn’t happen.
Swap spreads reflect the cost of funding a long treasury position, so negative spreads mean that it costs more to borrow cash for 30 years secured against treasuries than to borrow unsecured for 30 years. It means that lending to the US government is riskier than lending to its banks.
This is clearly nonsense, and back in 2008 it was a sign of how badly broken financial markets were as they fell into a global crisis.
But today there is no global financial crisis. And yet, once again, 30-year swap spreads are negative and have been since late 2014. In an even more remarkable development, swap spreads all along the curve are now in negative territory too.
In mid-November last year Ed Fitzpatrick, head of US rates at JPMorgan Asset Management, observed: “Swap spreads have tightened so aggressively they have defied expectations and some would say logic.”