So what does a shrinking swap spread mean anyway?
Two-year swap spreads are hitting record lows, an indication that banks have healed quite nicely from the financial crisis.
So what’s a swap spread?
An interest-rate swap is the rate to exchange a floating-rate note for a fixed-rate note, in this case for two years. The spread is the differential between that swap and a nominal 2-year Treasury note.
The 2-year swap spread tightened to less than 6 basis points on Wednesday, marking the lowest-ever recorded level on a closing basis, according to Richard Gilhooly, U.S. director of interest-rate strategy at TD Securities.
Swap spreads have been tightening all along the yield curve, but it’s been particularly acute among shorter maturities. To be sure, part of the reason is speculation the Federal Reserve could take actions that would help bolster the front end of the curve, such as lowering its rate of interest on excess reserves .
“A potential cut in the IOER is one reason for spread compression, while forward guidance and extended ZIRP are structural issues weighing on spreads,” said Gilhooly in a note to clients. “Year-end cash looking for a home is a more local reason for spread compression.”
But the two-year spreads are likely to continue coming inward irrespective of Fed decisions, and may even hit zero, says Thomas di Galoma, co-head of fixed-income rates trading at ED&F Man Capital Markets. That would mean 2-year swaps trade at the same level as comparable Treasurys, capping a broad trend of shrinking spreads since the
financial crisis, when they spiked higher.
Because banks and other financial institutions are the folks trading swaps, the tightening spreads indicate the health of the banking sector, and depth of liquidity in the market. Proactive deleveraging by the banks has helped improve their credit-worthiness (and lower their borrowing costs to boot ).
“You have seen a situation take place where all banks and all of the institutions that trade swaps are better credits,” di Galoma said. “This environment we’re in is extremely controlled. It’s extremely regulated, and there are fewer players in the swaps market.”
In that sense, swap spreads may be an indicator of broader economic health as well. Scott Grannis, former chief economist at Western Asset Management Company and currently a blogger. has called the 2-year swap spread one of his favorite economic indicators. In a piece last year — when the spread was already quite tight — he wrote:
“Swap spreads have a record — albeit not a very long record — of anticipating changes in the health of the economy. They rose in advance of the past three recessions, and fell in advance of the past three recoveries. Currently, swap spreads are unusually low, a sign that financial markets enjoy plenty of liquidity and there is little if any fear that conditions in the financial markets or the economy will deteriorate meaningfully in the next two years.”
– Ben Eisen
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