One of the supposed signs of ‘the end of U.S. exceptionalism’ is the negative swap-spread. Interest rate swaps involve the exchange of interest rate payments on a debt security for a set period, where one party receives fixed-rate payments and pays variable, while the other does the opposite. The swap spread is the difference between the fixed rate agreed to in the swap contract and the yield on a government bond with the same maturity as the life of the swap. A positive swap spread reflects compensation for taking on counterparty credit risk in the swap contract, while a negative swap spread implies counterparty credit risk is perceived to be lower than that of the government bond. Government bond risk relates less to default than to inflation, interest rate uncertainty and the regulatory cost of holding physical bonds.
At present, 10-year swap spreads sit -55 basis points (bps). The dominant market narrative is that capital regulations on U.S. banks and primary dealers are making it inconvenient for them to buy and hold physical government bonds. Recent history suggests that the larger the net outright holdings of banks and primary dealers, the more negative the swap spread. Although the Fed is now talking about relaxing capital regulations, so that banks have more balance sheet capacity to buy bonds. All other things being equal, one would expect swap spreads to turn less negative as a result, swap spread have hardly budged.
We see several reasons for this: (1) the Fed’s proposed changes do not exempt Treasuries from the leverage calculation used to determine capital surcharges on US banks and dealers, (2) even after the tweaks, it is unclear that banks and dealers have that much additional room to buy more Treasuries; (3) they may choose higher-return options elsewhere despite any extra capacity; and (4) banks and dealers are already deploying balance-sheet capacity in securities-lending trades backed by Treasuries, fuelling leverage across the system. That same leverage allows hedge funds to buy bonds and push yields below normal levels, which in turn supports equity valuations and the broader economy.
The upshot that there is substantial leverage already propping up bonds and related asset prices. Easing capital regulations may extend the trend, but the marginal benefit is diminishing. We do not foresee a wholesale unwinding of leverage yet, so we stay alert to repercussions for equities, especially growth names, while encouraging investors to hedge by reducing exposure to crowded favourites and considering unloved opportunities.
