RBS- US Strategy Focus I Swap Spreads

The precipitous decline in swap spreads that has occurred since August has been truly astounding. We blew through post-crisis lows more than a month ago with the 5-year spread crossing into negative territory for the first time ever.

Each time that we have started to hear chatter about the momentum potentially beginning to wane, we seem to get another leg down. This has made trying to call the bottom over the last few months a particularly dangerous pursuit.

However, looking at how far spreads have already fallen, it’s nearly impossible not to wonder just how far into negative territory spreads can go.

Ultimately, RBS don’t expect a significant retracement in the near-term and see the balance of risks still skewed to the downside. While there are several potentially compelling reasons to like spread wideners at these levels, they don’t expect the factors that have been driving spreads lower to significantly abate over the next several months.

While there are a myriad of reasons cited as to the cause of the collapse of swaps spreads, RBS focus on what they feel to be the three largest ones, ordered by importance and permanence: repricing of repo financing, record levels of corporate and financial issuance, and sales of Treasuries by foreign reserve managers.

Looking Ahead: Looking ahead to the next month or two, RBS continue to see the balance of risks for swap spreads as skewed towards the downside as many of the aforementioned factors seem likely to persist to varying degrees. As such, they are not expecting a significant retracement. However, as one of their short-end traders has noted, despite the inversion of GC-LIBOR, carry and rolldown remains positive for wideners, even if to a lesser extent than prior levels. If the current spread levels were to hold, these positions may still be attractive to some investors from a carry perspective. This could be particularly true for investors willing to fund the Treasury leg in 0/N repo, which has not fallen under the same pressure as term. However, with year-end looming and considerable uncertainty as to how funding rates will react to a potential Fed hike and the Fed’s new tools, continually rolling over overnight funding is not without its own risks.

Looking past the next several months, they see greater potential for spreads to widen out. As Fed liftoff commences, corporate and non-financial issuance should eventually become less robust. Appreciation of the dollar, and the subsequent flows from reserve managers, may also taper off as a more gradual path of hikes is realized and the initial reaction to policy divergence wears off. Theoretically, there is also a point in the rate cycle at which revenues for dealers will increase and balance sheet constraints lessen, reducing repo financing costs. But that is all in the future, for now, even if we’ve reached the bottom, there is likely to be little progress to the upside in coming months.

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BNP:-

Their US guys called the move lower pretty well. They think spreads stay structurally lower but think they widen out from here during Q1 on the back of the supply story and fed reinvestments

BNP: – BNP expect the new regime of negative US asset swap spreads to persist, as it’s driven by changes in regulation and balance sheet costs, which they do not expect to reverse.
– In the context of this "new normal", BNP believe swap spreads will respond to changes in the supply of Treasuries, as they have in the past. Due to a shrinking US deficit and hefty reinvestment of the Fed’s System Open Market Account (SOMA) program, Treasury supply, net of QE & reinvestments, should fall by 38% between 2015 & 2016.
– Therefore, they are shifting their stance on asset swaps from cautious to bullish over the short-term.
– It is difficult to calibrate what size asset swap move to expect in the new regime: recent experience suggests that the change in supply should move asset swaps by 8-12bp in 10y spreads. The 30y could move further, perhaps by as much as 15-20bp.
– As to the timing of the anticipated Treasury outperformance, looking at the distribution of gross issuance and Fed reinvestment, BNP would expect widening in the first quarter of 2016.
– Trade: Buy 10y headline asset swap spreads Entry: -13bp, Target: -3bp, Stop: -18bp, Carry: 0.5bp/