Besides the massive volatility and never before seen governmental intervention in the markets, there has been one particular area that has befuddled me. For those not in the fixed income markets, LIBOR based swap rates are supposed to be the interest rates at which financial institutions of a AA rating are able to lend to each other. There are different rates for different countries, but here we will focus on US $ based LIBOR.
There are some fundamental truths in how this should work. For one, the rate should be tied to the government treasury rates as financial institutions often borrow from the government to fund financial transactions. The “swap spread” is defined as the difference between swap rates and government treasuries. Take the 30 year swap yield, subtract the yield on 30 year treasury bonds and you have the 30 year swap spread. What this spread should tell you is the risk of AA financial institutions versus the government. We would expect that financial institutions should carry more bankruptcy risk than the US government. In fact, in times of major financial distress, such as the LTCM blowup we saw 30 year swap spreads skyrocket to 1.5% and up. In general, 30 year swaps spreads are usually stable at about 40-50 bps, or about .5%.
So that was a long winded way of getting to the problem. Starting in November of 2008, 30 year swap spreads turned negative – implying that it was less risky to borrow for 30 years from JP Morgan than from the US government. Not only did they turn negative, but they turned massively negative all the way to -59bps on November 20th, 2008. They went positive in December, but then slid back into negative territory and have stayed there since. Right now we are sitting at about -20bps.
So what is going on here? Every time an investment banker from the interest rate desk has come by I have asked them the same thing. The answers I get are always varied, but never adequate. I have even heard some suggest that the government is more risky over a 30 year time period than financial institutions, which I find hard to believe even if taking into consideration the massive government debt. The most plausible explanation is that we are seeing a technically driven demand/supply event where pension funds and insurance companies are hedging their interest rate exposures with swaps almost exclusively on the long end of the curve which has driven down the yield artificially.
The natural follow-up to the supply/demand equation is: why isn’t a big hedge fund or investor taking the other side of this trade? Sell swaps and buy treasury futures. This seems like a massive no-brainer to me. Maybe because the banks will not provide good short swap levels to hedge funds? Maybe the banks are artificially keeping swap rates below treasuries so that they can build up their own massive position on the long end of the curve and make a boatload of money when swap spreads revert back to the mean? That’s my feeling…
