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Hey Jay, Maybe Check The Swaps Before Committing to Taper

Summary:
It was said to be something hugely significant, truly momentous – but only until it started to misbehave all over again. This was the summer of 2013, SHIBOR Summer in China and the misunderstood, mislabeled “taper tantrum” in the US$. Consistent with the latter’s more optimistic take on the world, the 30-year swap spread turned positive for the first time since the worst of the 2008 crash.Ever since it first appeared late in 2008, a negative then persistently negative swap spread confounded and confused the world’s “experts”, especially those associated with the Federal Reserve. Not just that it shouldn’t happen, many before the worst of the Global Financial Crisis had come to believe it couldn’t happen. Why? To see the swap rate trade below its equivalent UST was akin to holy

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It was said to be something hugely significant, truly momentous – but only until it started to misbehave all over again. This was the summer of 2013, SHIBOR Summer in China and the misunderstood, mislabeled “taper tantrum” in the US$. Consistent with the latter’s more optimistic take on the world, the 30-year swap spread turned positive for the first time since the worst of the 2008 crash.

Ever since it first appeared late in 2008, a negative then persistently negative swap spread confounded and confused the world’s “experts”, especially those associated with the Federal Reserve. Not just that it shouldn’t happen, many before the worst of the Global Financial Crisis had come to believe it couldn’t happen. Why?

To see the swap rate trade below its equivalent UST was akin to holy financial blasphemy; it triggered an unending stream of confused consciousness that groped for some kind of window back to the safe reality that had once, seemingly long ago by that point, existed. A very big clue would surface just the next day, as stock markets all over the world crashed yet again on October 24. The S&P 500 was down more than 3.5%, with the DJIA off more than 500 points at the low. The NASDAQ would finish that week off just about 10%, making it -30% for the month of October.

The swap spread is itself a very simple matter: the raw difference between the quoted fixed leg of a vanilla interest rate swap and the same maturity nominal US Treasury yield. Interpreting this resulting spread, that’s the problem. By all textbook accounts, the former would never be less than the latter because if that ever happened this would seem to suggest the market pricing the US government as riskier than the financial counterparty on the floating side of the swap.

Yes, blasphemy but especially so only starting in October 2008 and continuing every month thereafter.

For this mainstream approach, such financial products are analyzed through this improper lens of generic “credit risk.” Throw that nonsense out the window; a negative swap spread isn’t about credit risk but liquidity and balance sheet capacity.

Quite simply, it takes some financial institution’s balance sheet capacity to take on an interest rate swap (the farther the maturity, the more capacity it requires). If balance sheet capacity (the real money in the system, therefore liquidity) is systemically impaired, as in a crisis, or a crisis that doesn’t really end, then to get dealers to give up their precious balance sheet capacity and engage on the other side of a swap someone would have to pay a hefty premium to make it worth it (risk-adjusted) for the dealer to do so.

In a swap, it would mean discounting the price of the fixed leg even to the point this fixed leg yields less than a UST of the same maturity. A negative swap spread, therefore, an indirect but reliable indication of systemic liquidity and balance sheet elasticity.

As I often have to at these junctures, I’ll write it again: bank reserves don’t matter.

Picking back up with the story of 30-year swap spreads in 2013, they would turn positive for the first time in nearly a half a decade. Hurray! This seemed to confirm the idea that QE’s 3 and 4 (yes, there were four) had finally done the trick. Normalizing the deepest parts of the financial system so that global recovery and inflation were maybe even probable for the first time (no more headwinds?) since those events of ’08.

Hey Jay, Maybe Check The Swaps Before Committing to Taper

The love affair didn’t last, however. Like eurodollar futures, the rise and positivity for the 30-year swap spread wouldn’t make it past September 2013; barely a few months real reflation. From then on, back to mostly negative until January 2015 when the 30s really plunged all over again. Needless to say, this inconvenient development meant their time on the front page of the Wall Street Journal had passed.

To try to explain why, various theories have been proposed since. The one which seems to have caught on is, I have to chuckle, central clearing. As part of the Dodd-Frank convolution, a blind political stab beyond simple subprime mortgages, authorities demanded more derivatives trade at clearinghouses.

As this did happen, back to credit risk evaluation: no longer is the other side of an interest rate swap solely some unrelated, unknown counterparty. The clearinghouse itself stands behind the clearing of any contracts therefore, so the thinking goes, markets are pricing less systemic credit risk for interest rate swaps in general.

Plausible, sure, if you don’t think too hard or much about it – just like bank reserves.

Hey Jay, Maybe Check The Swaps Before Committing to Taper

The truth is, as I already wrote, throw that nonsense out the window. Far simpler, more realistic is what I laid out above in terms of balance sheet capacity. The reason swap spreads swing about as they have over the years is corroborated many times over in the reflation/Euro$ cycles.

Higher deflationary potential due to rising liquidity risks because of greater systemic balance sheet constraints, watch what swap spreads do and how their general decline (and negatives) matches near perfectly with all the other market indications from eurodollar futures curves to TIPS breakevens to just plain nominal yields.

It cannot be random coincidence that swap spreads persistently compress time and time again as all these others trade systemically in the same deflationary manner.

The same is true for the converse, as it was – briefly – during the summer of 2013. A bit less (never too much less) deflationary potential due to slightly easing liquidity risks because of somewhat lower balance sheet constraints, market participants don’t need to pay that much of a swap premium so that fixed leg quotes can rise relative to the yield on the same maturity nominal UST.

The swap spread then can decompress – but only for a time because the system is never fixed, never more than a little reflation.

Hey Jay, Maybe Check The Swaps Before Committing to Taper

This is proving again to be true in 2021 despite the “too much money” theory as well as the lie about Jay Powell’s digital dollar flood. From the perspective of swap spreads, as you can see above, they never really decompressed (reflation) all that much and since about February 25 (there’s that date again) they’ve stopped altogether.

Since late February and March, the swap market is more like the same in 2018 or TIC of late; not exactly a good sign of budding and building inflationary pressures if you’re Jay Powell trying to avoid the same exact mistake in 2021.

Swap spreads tend to be more of a lagging indication, too, which makes their clear inflection earlier in the year that much more problematic for this upcoming taper.

Taper, as I’ve repeatedly warned, is little more than theater written up from mainstream econometric models in order to project confidence in a more optimistic intermediate and longer run forecast – a set of predictions that get made without taking any of these things, not just excluding swap spreads, into their account.

Therefore, unsurprisingly as usual, at the same time the Fed wishes to project such confident optimism (think September 2013), the actual money behind the global economy has turned away from it.

These people just never learn. In terms of swaps, they still think it has something to do with “credit risk.” It would be funny if the consequences weren’t so enormous. Again.

Hey Jay, Maybe Check The Swaps Before Committing to Taper Hey Jay, Maybe Check The Swaps Before Committing to Taper

Jeffrey P. Snider
As Head of Global Investment Research for Alhambra Investment Partners, Jeff spearheads the investment research efforts while providing close contact to Alhambra’s client base. His company is a global investment adviser, hence potential Swiss clients should not hesitate to contact AIP

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