Yield Curve Flattening Betrayed by Another U.S. Spread Widening

(Bloomberg) -- Not every spread in the U.S. rates market is shrinking. In fact, one benchmark measure is widening just about in lockstep with the persistently flattening Treasury yield curve.

The 30-year swap spread, which represents the difference between the rate on an interest-rate swap and yield on a similar maturity Treasury, is the widest since August 2015. It’s becoming less and less negative -- a legacy of post-crisis financial rules -- as a cocktail of potential regulatory forces is set to dim the allure of swaps relative to long-term government debt. Since the start of September, the measure has been a mirror image of the U.S. yield curve.

The widening swap spread further illustrates the insatiable appetite for long-dated Treasuries, which rallied Tuesday. At the same time, traders are ramping up expectations for Federal Reserve rate hikes next year, pushing rates on shorter maturities upward. The U.S. yield curve flattened to a fresh 10-year low Tuesday, and signs suggest the move still has momentum. 

The swap spread widener “remains one of the core trades,” said Glen Capelo, head of rates at Academy Securities. “As Dodd-Frank regulations get eased, the benefits to using swaps changes. This relationship has been directly correlated to the curve.”

The 30-year spread, which touched negative 19.1 basis points Tuesday, is on course to go flat, Capelo said. That means swap rates widen to match Treasury yields for that tenor, so the difference becomes zero. On average, the gap has been negative 11 basis points since the start of 2007 (and reached an unprecedented negative 61 basis points last year), compared to positive 58 basis points the decade before that.

It doesn’t really make sense for swap rates to be lower than Treasury yields because they contain credit risk from being priced off the London interbank offered rate. But post-crisis regulations made it more costly for dealers to hold government debt. 

Donald Trump’s election victory triggered much of the rebound over the past year, given his promises to ease the regulatory burden on Wall Street. 

If the recent trend between the swap spread and Treasury curve holds, further flattening may be ahead for the world’s largest bond market.

©2017 Bloomberg L.P.

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