Bloomberg News

U.S. Rate Swap Spreads May Widen as Demand for Treasuries Rises

November 14, 2012

Regulatory changes and an end to temporary deposit insurance on some bank accounts are likely to boost demand for short-term Treasuries and widen the difference between swap rates and Treasury yields from record lows, according to Bank of America Corp.

The difference between the two-year swap rate and the comparable-maturity Treasury note yield, known as the swap spread, touched eight basis points, or 0.08 percentage point, on Oct. 17, the lowest since at least 1988, or as far back as Bloomberg tracks data. The gap is likely to widen to about 17 basis points, Bank of America predicted, from 11.5 basis points yesterday. The 2012 high was 49 basis points on Jan. 3.

Two-year swap spreads may rebound on a possible drop in financing costs when the Federal Reserve ends short-term debt sales as part of Operation Twist next year. Demand for government debt may rise as margin requirements on swaps required by the Dodd-Frank Act are put in place and if the Federal Deposit Insurance Corp. ends, as planned next month, temporary unlimited insurance on non-interest bearing transactions accounts.

“Demand for Treasuries, particularly in the front end of the yield curve, is and will continue to increase while the supply is probably going to decline,” said Ralph Axel, a fixed- income strategist at Bank of America, in an interview. “These factors should cause an outperformance of Treasuries relative to swaps, widening spreads.”

Yield Range

The U.S. two-year interest-rate swap spread narrowed to a record low as the London interbank offered rate, the rate banks say they pay for three-month dollar loans, plunged to a 12-month low. The two-year Treasury note yield, at 0.25 percent, has traded between 0.19 percent and 0.41 percent this year.

The average rate for borrowing and lending Treasuries for one day in the repo market was 0.252 percent yesterday, according to index data provided on a one-day lag by the Depository Trust & Clearing Corp. The rate was at 0.127 percent at the start of the year.

Supply of Treasuries may decline if even a partial trigger of the $607 billion in tax increases and spending cuts, the so- called fiscal cliff, occurs next year. Strategists at UBS AG predicted the Treasury department will focus supply cuts to Treasury bills and short-term coupons if a below-forecast deficit cuts borrowing needs.

Budget Talks

“Fiscal-cliff risks are likely to push swap spreads wider in the near term on the back of falling yields,” wrote a team of analysts lead by Charles Diebel, head of market strategy at Lloyds Banking Group Plc in London in a note. “While a degree of money-market stress might help the move, we do not expect anything similar” to recent stress-induced widening, such as in May of this year.

The two-year swap spread rose to as high as 41.8 basis points on May 16 from 22.4 basis points on March 28. Spreads widened during that period as Spain struggled to recapitalize its banks and investors’ concern grew regarding Greece’s future in the euro and the ability of the region’s leaders to contain its sovereign debt crisis.

The swap spread is based in part on expectations for dollar Libor and is used to gauge investor perceptions of credit risk. Swap rates serve as benchmarks for investors in many types of debt, including mortgage-backed and auto-loan securities.

Finance Costs

Repurchase agreement rates, which primary dealers call repos and use to help finance debt holdings, have surged since the Fed began swapping short-term debt for longer-term Treasuries on its balance sheet last year in its Operation Twist program. The program is slated to end Dec. 31.

“A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity-extension program,” according to the record of the Federal Open Market Committee’s Oct. 23-24 gathering released yesterday in Washington.

The Fed’s latest round of debt purchases, known as QE3, may also be adding liquidity to the money markets, as it lifts banks reserves, Joe Abate, strategist at Barclays Plc. wrote in a note published Nov. 5. The Fed is buying $40 billion of mortgage- backed securities a month to put downward pressure on borrowing costs.

If the Fed were to add Treasury purchases, the 10-year interest rate swap spread could widen 10 to 15 basis points, according to Citigroup Inc. The spread was at 3.6 basis points yesterday.

Cash Shift

There is about $1.4 trillion in cash sitting in non- interest bearing transactions accounts with balances above $250,000 that is set to lose temporary unlimited insurance coverage put in place following the financial crisis in 2008, FDIC data shows. If even 10 percent of that cash makes its way into money market securities, it could push rates lower, according to strategists at Morgan Stanley.

Under the 2010 Dodd-Frank, dealers and money managers that trade swaps will need to find cash and securities to back the trades sometime next year, boosting the demand for short-term Treasuries, according to Axel. Under the Commodity futures Trading Commission rules, clearinghouses are required to collect initial margin, the minimum amount of cash or eligible securities investors must deposit to cover the risk of default.

Dodd-Frank Act is requiring swaps be moved to central counterparties to limit the kinds of risks that fueled panic during the 2008 credit crisis. Firms dealing in $648 trillion of outstanding swaps contracts will have a phase-in period initially next year where trades won’t need to be processed by central clearinghouses.

“The market currently expects the swaps-clearing portion of Dodd-Frank to be implemented sometime in Q1 or Q2 2013,” New-York based Citigroup strategists Neela Gollapudi and Andrew Hollenhorst wrote in a note published on Nov. 2.

To contact the reporters on this story: Liz Capo McCormick in New York at

To contact the editors responsible for this story: David Liedtka at dliedtka@bloomberg.net


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