The Underappreciated Swap Curve: A Closer Look
Fixed Income Perspectives by Christian Brobst
December 4, 2018
If you are watching for yield curve inversion, it might be closer than you think. Just as we have talked about there being a market of bonds—not a bond market—the same can be said for yield curves. Taking a broader view may provide valuable insights about the market psyche.
Depending on who you talk to, there are many views about which maturity points along a yield curve are most important for understanding what will happen next in the economy—and how soon. For the media and market traders, the most watched yield relationships is the slope between two-year and 10-year Treasury yields. The difference between the two has fallen under 15 basis points, a new low during this economic cycle. Many economists view the three-month 10-year Treasury curve as a more important indicator of economic slowdown. That curve is steeper (or “more positively sloped”) at 54 basis points, although it has declined by roughly 35 basis points since the beginning of November.
It’s also important to note that although the Treasury curve dominates the United States market, the interest rate market consists of several yield curves. The swap1 curve, in particular, deserves greater attention from investors. The slope between two-year and 10 year rates is in a low-single digit range, and the three-month 10-year curve is under 25 basis points, less than half the three month-10 year Treasury curve slope. Moreover, all tenors of the swap curve between two and seven years are now trading in a three basis point range, with many of the front-end relationships inverted.
Many investors think of the swap market as a hedge vehicle, where corporate or government borrowers can swap fixed and floating payments with banking institutions to suit their financing needs. But over the past 25 years, the swap market has expanded to include traditional asset managers and hedge funds. When accounting for all dollar-denominated interest-rate derivatives, the Bank for International Settlements reports a notional value of more than $192 trillion of contracts outstanding as of June 2018. This dwarfs the size of publicly held U.S. Treasury securities ($15.5 trillion). To be fair, measuring the size of the interest-rate derivatives market using notional value outstanding is only one way to do it. But even the market value of outstanding interest-rate contracts is significant at $1.3 trillion, and many debt instruments are benchmarked against the swap curve as opposed to Treasuries.
For those that think first of derivatives as illiquid, the liquidity of the swap market may come as a surprise. Across most tenors, the swap market can be more liquid than the Treasury market. This is true whether you measure liquidity by the size of the trade that can be executed without moving the market or by the breadth and depth of “prices” available at any given time.
Increasingly, this better liquidity has led investors to the swap market to express outright views on interest rates. In addition to the liquidity benefits, the cash required to enter into a swap trade can be a fraction of what it would cost to purchase Treasuries outright, even taking into consideration the availability of repurchase agreements to help fund positions.2 This makes swap trading a more efficient use of capital for investors to gain similar exposure to interest rates.
Of course, there are important differences in the level of technical complexity between swaps and Treasuries. For example, swap rates include a spread component that can be traded separately from the underlying Treasury rates. To be clear, we are not suggesting the primary benchmark yield curve for inversion—and recession predictions—should become the swap curve. Rather, we believe considering both the Treasury and swap curves can provide a more complete picture of the interest rate environment, especially as the swap curve is likely to invert before the Treasury.
The Federal Reserve does not want to see yield curve inversions, as they are widely regarded as a precursor to recession. (The timing between inversion and recession is debatable, see Matt Freund’s post, “Avoiding the (Yield) Curve Ball.”) Yield curve inversion also means banks earn less from lending money, which discourages the flow of capital through the economy. All this supports our long-standing expectation that the Fed is likely to hike the federal funds rate a couple more times to the 2.5-2.75% range and press pause to evaluate the impact of its actions.