Forex Investment and Currency Trading

Since early February, swap spreads in the major markets have moved meaningfully wider. As usual, swap spreads are tales of two ‘legs’ – bonds and swaps. In recent weeks, however, attention has been given mostly to the bond ‘leg’ amid rapidly deteriorating government borrowing and rising prospects for bond purchases by central banks.

A closer inspection of the two swap spread ‘legs’ separately, suggest that most of the rewidening in swap spreads, particularly in Euroland and the US, is attributed to the cheapening of swaps. The latter reflects the recent re-appraisal of interbank pressures, in part stemming from the rise in the cost of credit protection on Libor-panel banks’ debt. To see this we can slice the swap spread into two sub-layers using OIS rates (a proxy for policy rate expectations) as a divider. Using this metric, we note that since early February, the US/UK/Euroland average swap-OIS has widened by 25bp at the 2ry sector (to over 100bp) and by 20bp at the 10yr sector (to nearly 90bp).

In the UK, the cheapening of intermediate swaps has most recently coincided with the richening of intermediate Gilts on the back of the BOE’s surprise decision to buy securities with comparatively high duration. The combined effect of these broadly unexpected forces has pushed the 10yr swap spread wider from negative levels to nearly 40bp currently.