Wednesday, March 31, 2010

The Debts of the Spenders: Explaining Negative 10 Year Swap Rates

The yield inversion is a sign of hedging risk against more volatility in the coming months as desks are worried about a potential rise in rate risk.

One possibility behind LIBOR being less than the 10 year yield is that major banks are not positioned properly for it and will lose heavily. But this is not the same thing as a "Black Swan" type event that some commentators are calling for. Certainly not as bad as when the TED spread >4 in Fall 2008. Eurodollar forward contracts are not pricing in disaster as they continue to reflect a belief in ZIRP through the end of 2010.

Indeed, the Fed has stated it has no intentions to raise interest rates soon as they are still testing ways to withdraw the quantitative easing policy that was initiated.

There are three Fed meetings between now and the expiration of the Sept Eurodollar contract (9/13).

Apr 27-28

June 22-23

Aug 10

The job and housing market remain very weak. Inflation remains in check.

In fact, the negative swap rate seems to be NORMAL given the search for yield among fund managers (e.g. demand for higher-yielding assets such as corporate bonds and emerging market securities). A bond is a contract that involves at least two parties. The fund manager buyers are one party. The other is the bond issuer seeking to hedge risk (primarily interest rate risk) .

With low interest rates projected to stay (and the majority of corporate deals still dollar denominated) at ZIRP for the remainder of 2010 and all these corporate borrowers (bond issuers) seeking to sell their debt it is no wonder that swaps turned negative.

But what of the timing you ask at the end of March? The timing can be explained by the end of Bernanke's TOMO MBS program. With the Fed seeking to exit the agency debt market, there are players eagerly waiting to enter the private market again (agency debt market dried up by Q3 2007). There are even NEW private securitization deals happening again (my colleagues at the NY Bar say there are signs of greater deal flow again in the pipeline). The nature of corporate America is to shy away from risk so while they are all eager to make some money they are also reluctant to make the first move. All this explains the heavy demand for swaps.
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