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Negative Swaps Herald Government Bond Market Trouble?

In recent years, a key axiom that every investment manager learnt at school (or, more accurately, in an MBA class) was that the rate at which triple A-rated countries such as America could borrow money could be labeled the "risk-free" rate - and corporate (and) other borrowing costs could be measured against it.

But is it time to rethink that "risk-free" tag? If you look at what is happening in the US and UK interest rate markets right now, the answer is "yes".

From time immemorial, it has been taken as self-evident that the swaps spread in debt markets should be "positive". What this so-called "swaps spread" essentially measures is the cost of borrowing funds in the Libor market (for a private companies, such as banks), minus the cost of raising government debt.

And, since the private borrowing costs are influenced by credit and counterparty issues (ie: whether banks default or fail to repay), logic suggests those Libor rates should be higher than sovereign borrowing rates.

After all, triple A-rated central government is supposed to the safest thing about. But now, as my colleagues Michael Mackenzie and David Oakley first reported two weeks ago, something bizarre is going on. Back in 2008, after the collapse of Lehman Brothers, the 30-year swap spread turned negative, when the markets froze amid wider financial chaos.

At the time, that swing did not grab many headlines, partly because the 30-year market garners little attention in the US. However, last week the closely watched - and vastly more influential - benchmark 10-year swap spread turned negative too, as 10-year Treasury yields spiraled up towards 4 per cent and above the 10-year swap rate.

That may simply be a temporary aberration. After all, the swaps market is not a perfect barometer of macroeconomic conditions and some unusual supply-demand imbalances seem to be distorting the market.

One issue affecting spreads, for example, is that investors are changing the way they hedge mortgage-rate risk, since the Federal Reserve is due to stop buying mortgage-backed securities tomorrow.

A second factor is that more pension funds are trying to use swaps for meeting long-dated liabilities, rather than committing capital to buying bonds, at a time when government bonds are losing their scarcity value because of massive issuance.

Canary in the Coal Mine?

At the same time, a flood of corporate issuance has left an unusually high number of entities swapping their fixed liabilities for floating exposures. More importantly, there are rumors that some banks and hedge funds have recently suffered losses because they were wrong-footed by the swap swing. If so, they may be trying to cut their positions, thus exacerbating market movements.

However, there is another, less benign explanation for what is going on: namely that what we are seeing is a "canary in the coal mine" (to use the pithy image used by Alan Greenspan, former Fed chairman, last week), heralding future government bond market trouble and investor panic.

Think back, for a moment, to the summer of 2007, or just before the start of the subprime meltdown. Back then, it was not the equity and credit markets that signalled disaster. Instead, the main sign of spreading investor alarm was that prices started to swing in the more obscure world of credit derivatives indices (such as ABX) and asset-backed commercial paper (ABCP).

This time round, is the swaps market another version of, say, ABX? Perhaps not yet. Personally, I will be astonished if countries such as the UK and US entirely avoid a government bond market shock; but I also suspect that this will occur some time down the road.

Nevertheless, if nothing else, the swaps spread swing does suggest that some investors are getting jittery. It also serves to underline that we do not live in "normal" markets right now. While the surface may look calm, the inner cogs of the financial system have been distorted by government intervention in ways that are still barely understood.

That, coupled with spiraling levels of government debt, has the potential to cause all manner of investment assumptions to go awry. Some trading desks and hedge funds are probably already counting the cost of that. As I noted above, the swaps spread swing has almost certainly created losses somewhere, given that it was not factored into most trading models.

But the story is unlikely to stop there. If we are moving into a world where government debt is no longer automatically deemed "risk-free", partly because it no longer has any scarcity value, this will be a different world to the one investors know.

In the months ahead, in other words, investors and politicians had better keep watching this swaps "canary". Especially (but not exclusively) in the ever-expanding world of Treasuries.

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