The Debts of the Spenders: More on Negative Swap Rates

This post is a continuation of the immediate prior post. Here are some questions that I received.


Q) Wasn't the credit crisis driven in part by low interest rates that made investors search for higher yield (risks receiving too little attention)?

A) Yes. But this is part of the West's "Extend and Pretend" recovery rally. If a bank wrote down $40 billion loss in 1 year, they could theoretically break even by making $10 billion/quarter for 4 quarters. Obviously this enthusiasm is not reflected by emerging market nations like India and China which have tried to reign in their own markets by raising rates and/or withdrawing liquidity.

Unlike 2004 (when the markets were also preparing for the end of Quantitative easing) there is a coordinated movement among Western governments (US, Canada, UK, and the Eurozone) and Japan to keep rates low.

Q) Can it be that the negative swapspread partially reflects a credit concern in Treasuries (if cannot be good that Buffett borrows at lower rates than Treasuries - http://www.linkedin.com/redirect?url=http%3A%2F%2Fwww%2Ebloomberg%2Ecom%2Fapps%2Fnews%3Fpid%3D20601087%26amp%3Bsid%3DaYUeBnitz7nU&urlhash=NIeB )?

A) Yes and no. It is not so much credit concern as it is the supply issue. Many bond traders (myself included) believe the 10 year will break 4% by this summer. Temporary factors contributing to a rate rise include Obama's Health Care monster bill. But a weak economy driven by deflation and labor figures should drive the 10 year yield below 4% again by December.

Additionally, the Europeans look very weak. Where are traders going to park their money? In pounds and euros? Ha.

The US certainly is not suffering from the same legitimacy questions as Greece, the UK, or Eurozone. That is because the US has 2 magic bullets to refinance its needs - China and Japan.

Q) Why are companies hedging all their long-term interest-rate risk exposure? Doesn't that increase their risks if short-term rates rise again? Do they have too much of a short-term focus?

A) See my answer regarding coordinated Western govt action on rates. The Japanese are also doing their part to fuel the carry trade. So long as they borrow in dollars or yen then there should not be a problem. The market seems confident about the remainder of 2010 but is unsure about the next few years. Hence the need to hedge.

I am also looking at the options volatility for the tone of the market.

The following is a direct quote from http://www.optionszone.com/market-commentary/options-activity/2010/03/iron-condors.html

"We seem to be at a crossroads with options these days. On one hand, most
options have an implied volatility near 52-week lows. Who would want to sell
options when they are this cheap?

On the other hand, the only important aspect of an option's volatility is whether it is too high or too cheap relative to the volatility of the underlying instrument itself going forward. Spreads tend to work best as they have the defined risk and defined reward. You can make the same risk case with a straight buy though. All things considered, I prefer taking in credit."

I slightly disagree with the author to some extent and believe that sometimes it makes sense to lay out some debits at these low volatility points. He is championing an iron condor strategy - something that can be very expensive for traders to take on.

Q) It is a sign of confidence that investors are willing to buy long-term credit. But will these turn out to be good investments? The term 'wall of debt' has been used (e.g. http://www.thedeal.com/newsweekly/features/that-worrying-wall-of-debt.php

A) The best bond deals are over. Gone are the days when you could buy at vast discounts to par and make 400%-500% in a bond (no, I am not making those figures up - see the preferred/ hybrid offerings for US financials in 2009). The nature of Wall Street is a herd driven mentality. These are the latecomers who are trying to sell their offerings to investors. For the past few months, bond fund inflows have beat equity inflows. That is why forward thinking traders are shifting focus to equities again and commodities. Just look at oil's rise. Corporate coffers are full of cash again and CFOs may commit to stock buy backs this summer (but probably not at these technicals).