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Market Voice: A negative for swap spreads

Ron Leven
Ron Leven
Macro Strategist for Brick Accretive Management

U.S. dollar swap rates are in uncharted territory after the two-year spread recently turned negative. This month’s Market Voice examines how the bond issuance required to fund the widening U.S. fiscal deficit has been impacting shorter-dated swap spreads.


  1. Swap spreads for most securities vs. Treasuries tend to diminish as interest rates decline, but the recent dip of the two-year spread into negative territory has been unprecedented.
  2. A combination of a widening U.S. fiscal deficit and central bank balance sheet adjustment is unleashing a flood of U.S. Treasuries onto the market.
  3. A normalization of the spread on 10-year swaps should be taken as a signal for a resumption of the long-standing bull stock market trend.

Since the U.S. Government has unlimited capacity to print dollars, there is implicitly little chance there would ever be a default on Treasury debt, so the Treasury curve traditionally serves as the benchmark for risk-free rates.

Other fixed income securities typically trade at a spread over Treasuries with that spread serving as a proxy for their relative risk of default.

However, the chart below (Figure 1) shows the emergence of negative spreads vs. Treasuries for the two-year and 10-year maturity USD swap rates.

Since interest rate swaps do not require any exchange of principal, the exposure to default is modest but still existent.

For instance, if an investor is receiving a fixed rate and paying floating through a swap agreement and the counterparty fails to perform, the investor would be forced to replace the fixed stream at the current market rate, which could be less attractive than the swap.

While there is no principal at risk, there is potential rate exposure. This default/credit exposure would seem to argue that swap rates should trade above Treasuries.

The 10-year spread has been drifting lower for the past 12 months and moved into negative territory in the middle of this year. A negative 10-year spread is unusual but not unprecedented — as shown in the chart it was also negative as recently as the late months of 2017.

Negative swap spreads

Part of the explanation of the negative 10-year swap spread is the tracking with the outright 10-year rate.

Lower rates are associated with modifying credit risk because this reduces the burden of debt service and hence makes default less likely.

Spreads for most securities vs. Treasuries tend to diminish as rates decline. The recent dip of the two-year spread into negative territory, however, is unprecedented, so it seems there is more going on than just lower rates.

Figure 1: 10Y vs. 2Y U.S. Treasury curve inversion and quarterly GDP growth

10Y vs 2Y US Treasury curve inversion and quarterly GDP growth. A negative for swap spreads
Source: Eikon

It is counter-intuitive that longer rates would be more prone to negative spreads as typically the longer the maturity the higher the risk of default, but the answer may lie in market friction.

The chart below shows a rough picture of the maturity allocation of U.S. Treasury debt by year based on what the Treasury reports for debt within general maturity buckets.

Most government bonds have short-term maturity and there is especially little supply in the 10 to 20-year bucket so thinner liquidity could create market friction explaining the slight – 10-15 bps – negative spread.

Figure 2: Maturity profile of outstanding U.S. Treasury debt

Maturity profile of outstanding U.S. Treasury debt
Source: U.S. Treasury

A monsoon of short-term debt

The unprecedented negative spread for two-year swaps cannot be blamed just on diminished credit spreads and appears to be a by-product of supply conditions.

The widening U.S. fiscal deficit has led to roughly a US$1 trillion rise in Treasury issuance since the end of last year and as shown in Figure 3 below, the increase in Treasury debt was particularly aggressive in the first half of this year when the swap spread went negative.

As is also shown, the Federal Reserve’s unwind of their Treasury holdings has added an additional $100 billion in Treasury bond supply this year.

And the Fed is not alone. A recent Reuters study indicated that the dollar share of global reserves is at its lowest level since 2013, in part reflecting central bank efforts to counter the general weakness of global currencies against the USD.

The combination of a widening U.S. fiscal deficit and central bank balance sheet adjustment is unleashing a flood of U.S. Treasuries onto the market. As indicated above, most of the debt is short-term creating a supply pressure on the shorter-dated Treasury market, hence the unique pressure on the shorter-dated swap spreads.

Figure 3: Treasury debt and Federal Reserve holdings of Treasuries – monthly changes

Treasury debt and Federal Reserve holdings of Treasuries – monthly changes. A negative for swap spreads
Source: Eikon

The spread inversion at the front end of the curve also may reflect the recent disruptions in the repo market.

As shown in Figure 4, it is not unusual for the repo market to be erratic at year-end, but the September rate surge was extreme, and not in line with normal seasonality.

Although the repo market has stabilized, the cause of the surge is still not well understood and this makes it difficult to rule out a recurrence. The disruption in the relationship between the repo and LIBOR rates is probably making it difficult for investors to arbitrage the negative two-year spread.

The arbitrage would require paying the two-year fixed swap leg and receiving LIBOR versus receiving the two-year Treasury rate funded in the repo market.

But the volatility and spikes in the repo market makes the relationship between the repo rate and LIBOR unstable, so this combination is no longer a low-risk arbitrage.

Figure 4: The USD overnight repo and 3M LIBOR rates

The USD overnight repo and 3M LIBOR rates. A negative for swap spreads
Source: Eikon

The implications of negative spreads

In principal, the negative swap spreads should be an arbitrage opportunity but this only holds for investors comfortable taking exposure to the repo market, and there is no guarantee that the spread will not widen further before normalizing.

As shown in Figure 5, the longer history of the 10-year swap spread suggests the stresses in the money market are somewhat negative for stocks.

The rebound of the stock market in the first half of this decade ran into serious resistance in conjunction with the 10-year spread going negative and equity prices went into an extended two year period of consolidation.

The uptrend resumed at roughly the same time that the spread reverted back toward positive. Similarly, the 2019 new-year rally ran into resistance as the 10-year rate spread went negative.

Over the past year the Market Voice has posited that the two historical precursors for a bear market — sustained curve inversion and significant real Fed Funds — have yet to emerge, so it is premature to look for the end of this bull market.

But the swap inversion suggests that upside is limited. However, we would look for a resumption once the rates market normalizes.

Figure 5: The 10-year swap spread and the SPX

The 10-year swap spread and the SPX. A negative for swap spreads
Source: Eikon

Swap spreads: The bottom line

While the 10-year swap trading through Treasuries is unusual, the negative spread seen for the two-year swap is unprecedented. The Treasury yields may be suffering from the heavy supply of issuance required to fund the growing fiscal deficit.

The fiscal generated supply is likely to persist, but arbitrage may eventually revert the swaps back to a positive spread, particularly if the repo market remains stable.

History suggests that the stock market will have difficulty making new highs as long as the negative 10-year swap spread persists, but normalization of the spread should be taken as a signal for a resumption of the long-standing bull stock market trend.

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