U.S. 10-year swap spreads may widen after inverting, BofA says

THE DIFFERENCE between U.S. 10-year interest-rate swaps and Treasuries of comparable maturity turned negative for the first time in two years in September.
Posted 10/2/12

NEW YORK - The difference between U.S. 10-year interest-rate swaps and Treasuries of comparable maturity may widen as changes in fiscal, monetary and regulatory policy limit the debt’s supply, Bank of America Corp. said.

The gap between the two inverted, or turned negative, on Sept. 20 for the first time in two years, as investors speculated the Federal Reserve’s Sept. 13 announcement that it will buy $40 billion of mortgage bonds a month until an economic recovery is fully established would lead investors to price in a higher rate of inflation and push up Treasury yields. It may widen as much as 40 basis points in a reversal of the trade that pushed the spread to negative 0.06 basis point on Sept. 20, according to Bank of America.

“If the stars align here, it could be a pretty big spread widener,” said Ralph Axel, a government debt strategist at Bank of America Merrill Lynch in New York in a telephone interview. Those events could add between $500 billion and $1 trillion of additional demand for the debt, he said. The different sources of risk “all kind of compound each other,” he said.

’Fiscal cliff’

The year-end expiration of Bush-era tax cuts and payroll levies may limit supplies of Treasuries, Axel said. A possible resumption of purchases of U.S. government securities by the Fed, the end of unlimited government insurance on non-interest- bearing accounts and clearing rules adopted as part of the Dodd- Frank financial law all have the potential to boost demand for Treasuries, he said.

Swap rates for 10-year debt have averaged about positive 36.6 basis points during the past 10 years. In a swap, two parties agree to exchange fixed for variable-rate payments over a set period. The swap rates are higher because the floating payments are based on interest rates that contain credit risk, such as the London interbank offered rate, or Libor.

The 10-year swap spread was nine basis points on Sept. 12 and averaged 12.44 basis points during the previous six months. The spread had reached as high as 21.81 basis points on June 1 as Treasury bond yields plunged to a record low after a Labor Department report showed the economy added fewer jobs than forecast in May.

“If you really are getting a fiscal cliff of any size, then you probably are getting a significant slowdown in the U.S.,” Axel said. “If the U.S. is slowing, that’s not good for anyone, and could worsen Europe. If you do have a worse Europe, you have an increased demand for Treasuries.”

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