By Kevin Muir
Today’s topic will once again involve swap spreads. I am admitting this fact up front in the hopes of convincing you to read on. I know many readers find this obscure part of the institutional fixed income market complicated, and more often than not, boring. I get it. It’s not nearly as exciting as reading about strapping on some S&P 500 risk, or selling VIX, or god-help-you, buying the latest ICO offering. But I firmly believe that negative swap spreads were an anomaly from the 2008 Great Financial Crisis, and monitoring their return to “normal” levels offers some important clues as to the development of the economic recovery. It is an important indicator that many strategists are missing.
I have long been banging on the table that shorting swaps was a better way to position a portfolio for rising long term yields – A Better Way to Short the Bond Market? I don’t want to repeat the same argument again, but let’s have a quick recap. When the Great Financial Crisis hit, most market participants would have assumed that swap spreads would have exploded higher, much like they did during the Long-Term-Capital-Crisis. In the past, worries about credit risk from the banks that issue swaps meant that investors bid up the price of risk-free US Treasuries, sending the spread soaring higher.
In the initial days of the Great Financial Crisis, US swap spreads did in fact start to widen. But then, much to almost everyone’s surprise, swap spreads collapsed below zero. It made no sense. Why would investors ever enter into a swap arrangement with a bank that has credit risk instead of just buying US Treasuries? Especially in those days when no one trusted the financial soundness of banks.
Well, the answer was that it had more to do with financial system’s plumbing than a logical decision by markets. And the next time some newly-graduated-business-school-keener lectures you about Professor Malkiel’s market efficiency theories, just show them the chart of the US 30-year swap spreads and ask them to explain it.
Swap spreads dove because the supply of bank balance sheet was dramatically curtailed. Basically, banks, faced with more regulations and increased capital requirements, withdrew their participation in the swap market. The demand for swaps fell but not as quickly as the supply. The end result was that this mismatch of demand-supply meant that the previously unthinkable occurred, and swap spreads went negative. What would have usually been arbitraged away by proprietary trading desks at banks and other financial institutions was left to persist for years.
And this strange condition was symptomatic of a bigger problem. After witnessing some truly asinine moves by the likes of Dick Fuld’s Lehman or the myriad of other banksters, governments and regulators were eager to make sure it did not happen again on their watch. So they clamped down on both credit and leverage.
Therefore it is no surprise that banks withdrew from extending their balance sheet for swap trading. With higher capital requirements and more scrutiny from regulators, most banks made the decision it wasn’t worth it.
This might have been fine if it was only swaps that banks abandoned. However, the sad truth was that this phenomenon occurred over many different business lines.
Which brings me to my theory as to how swap spreads are a great indicator as to banks’ willingness to expand the money supply through private sector credit creation. And although many market participants focus on quantitative easing and other high powered money supply levels to measure potential inflation, the truth of the matter is that private sector money creation is much more important. Monetary velocity change can often overwhelm monetary policy effectiveness.
Since the GFC, all of that monetary velocity change has been to the downside. Liquidity has been stuffed into the system, and instead of it being taken up and lent into the real economy, it has either sat inert on banks’ balance sheets or been used for financial engineering. This is why both velocity and swap spreads have plunged together.
Don’t look now, but with both the passage of time, which helps erase the GFC nightmares, along with Trump’s deregulation and pro-business push, swap spreads have been rallying hard.
We are now only 14 basis points from zero at the long end of the curve. Since Trump’s election, we have rallied 40 basis points.
Private sector credit creation is headed higher. Swap spreads are screaming that reality loud and clear. And most likely monetary velocity will be right behind.
All of this means that interest rates are probably also headed higher. Don’t forget that much of the economic bears’ arguments centers around the belief that over-indebtedness will cause private sector credit demand to roll over earlier than would otherwise be the case. They are convinced that the private sector will not be able to expand credit. They argue Central Banks are pushing on a string.
Well, they might be right, but I don’t know how anyone can forecast how much debt is too much. Many of these arguments were made at 50% of GDP. Then at 60%. Again at 70%, etc… Over the decades, their arguments haven’t changed. Sure you might argue that from a societal point of view we have hit the point of debt being a serious long-term problem. But that’s a qualitative decision of what should be instead of an actual acceptance of what is.
Have a look at this chart of the Total Credit to Private Non-Financial Sector as a percent of GDP:
It’s easy to see the reduction in credit from 2009 to 2011. But as much as everyone is bemoaning the increase in total credit during the past decade, non-financial private sector credit growth has been limited. We are nowhere near the levels of 2008.
Instead of trying to decide when we will hit the debt saturation point, I am instead going to look at the change in swap rates for clues as to the private sector’s willingness to create credit. And it’s continuing to give a clear signal. The private sector has begun to re-lever, and unless you see signs of that changing, there is little reason to expect this trend to stop.
What does that mean for financial markets? Well, more credit creation means more US dollars. Big time. If this trend continues, it will mean an even lower US dollar and bond market.
Thanks for reading,