Swap spreads shake-up

A RV analysis piece

Good morning everyone, this is a short piece of analysis on what is happening in the world of swap spreads, specifically the USA. This will be a piece free for all subscribers.

Since the start of the year swap spreads have widened following comments from Fed officials about possible SLR reductions. Fed Governor Bowman, who emphasized the need to reform the SLR to support Treasury market intermediation.

Fed Chair Powell reinforced this by stating that adjustments to the SLR calibration could help improve the Treasury market structure.

You can see below that it happened along all tenors of swap spread curve, with the 30y tenors having the most powerfull move.

Let’s start, first, explaing what is the swap spread. Basically, in the USA, it is the difference between the fixed rate of an interest rate swap and the yield on a comparable maturity US Treasury bond.

On Bloomberg you can find the ticker (USSFCT10 BGN Curncy) as USD SOFR SWAP vs Govt Bond 10Y.

This spread has been negative (with US govt yield higher than swap rate) in recent years, particularly at longer maturities after the shift from LIBOR (London Interbank Offered Rate) to the Secured Overnight Financing Rate (SOFR) as the benchmark for US dollar interest rate derivatives . This has significantly impacted swap spreads, SOFR is generally lower than LIBOR.

Turning now again on regulation, the SLR (supplementary Leverage Ratio) requires banks to hold capital against all assets without risk weighting, making it particularly relevant for U.S. Treasury (UST) trading and repo markets.

Lowering the SLR from 5% to 3% (as the rumors say at present) could free up about 4.6trn dollars in bank balance sheet (according to GS calculation) allowing banks to buy more treasury for market making reasons, and this could widen swap spreads by 20-30 basis points more.

In fact, a 2024 Fed study found that the SLR is the most binding constraint for two of the six largest Treasury dealers.

What are the read-across of these news on european swap spreads? Last week swap spread in eurozone, ASWSHTZ (asset swap for Schatz) and ASWBUND (asset swap for Bund) felt the pressure from US move, but the impact going forward will be limited, as this SLR positive impact will no apply to foreign bonds (european bonds purchased by US banks).

An other point to consider is that swap spread for Schatz, Bobl, Bund and Buxl, (contrary to what happened in the United States) have always been positive (i.e. with government rates lower than the respective bonds), with the most widespread perception that German bonds are materially closer to risk free assets.

In the chart below we can see that ASW for Schatz was above 100bp (2y germany bonds trading 100bp below swap). This was also a technical effect related to asset scarsity, with low supply of bonds absorbed by ECB quantitative easing and ECB buying high volume of governments bonds.

Now, with news related to a peace talks between Trump and Putin (and maybe also Zelenensky) a great part of the US related move on european asset swap reverted, with the risks for european countries to finance more and more military expenses to defende Europe. This could comes from higher Nato expenses or from buying more weapons from US and sending it to Ukraine. No matters"!

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Credit from macro to micro.