US and European swap spreads
The following analysis is taken from CSFB’s European Credit Strategy from 22 April 2004 by
William Porter, and explains our reasoning for the differences between US and European
swap spreads. While the levels may be different from last April, the drivers of spreads remain
the same.
We refer throughout to asset-swap spreads (of government bonds, which tend to be negative)
rather than swap spreads (to governments, which tend to be positive). On balance, we think
that it is slightly clearer1 for our purposes and reflects the fact that in Europe, swaps are now
the unchallenged interest rate benchmark, a fact that is itself important to our analysis of
spreads.
Asset-swap levels are very different between the US and German government markets.
Chart 1 US and German government asset-swap spreads v maturity
0
-5
-10
-15
-20
-25
-30
-35
-40
-45
-50
Oct-03
Mar-09
Sep-14
Mar-20
Aug-25
Feb-31
Aug-36
Source: Credit Suisse First Boston
We see the differences having three main components: funding, benchmark effects, and
market structure.
The LIBOR2-repo spread is the cost of the floating leg of a government asset-swap trade. The
total carry on such a (long government) trade is (government yield) – repo rate – (swap yield
– LIBOR), which equals (asset-swap spread) – (LIBOR – repo). It follows that, if there is a
structural reason for LIBOR-repo levels to be different between two markets, implying that
those differences are expected to persist indefinitely, there should be an equal structural
difference in asset-swap spreads.
Such a structural difference exists between Europe and the US3. 6m Euribor-German
government repo is currently 8bp, compared to 16bp for the US equivalent. The 8bp
difference is in line with historical norms. Adjusting both asset-swap curves by LIBOR-repo, to
arrive at the net carry of a long government asset swap, gives the following.
1
And "cleaner", containing no curve element. Even so, for these purposes, one may effectively be considered the
inverse of the other.
2
The market often uses the term (euro) "LIBOR" where it really means Euribor. We follow suit here in the interest of
brevity.
3
In summary, USD LIBOR trades above repo by the full cost of crossing the banking system’s balance sheet
because that is how the large banks on the panel operate. Euribor is more a mid-market rate due to the broader
cross-section of banks, who tend to be payers as well as receivers of the offered rate.
Chart 2 US and German government asset-swap spreads, plus 16bp for US and
8bp for Germany. Approximates to net carry of long government asset swap trade.
10
0
-10
-20
Feb-14
May-13
-30
-40
-50
Oct-03
Mar-09
Sep-14
Mar-20
Aug-25
Feb-31
Aug-36
Source: Credit Suisse First Boston
From this chart, it is clear that the different asset-swap spreads are dominated from the US
side. The German curve has some small benchmark effects, but is otherwise close to flat
carry throughout. The market is largely indifferent to euro swap vs German government risk.
See European Credit Strategy (ECS) of 11th December 20034 for a full discussion of this, and
why we regard it as sustainable.
In contrast, the US has large benchmark effects. Notably at the long end, where issuance has
been suspended, and at the 10yr point. Here, not only the 10yr on-the-run, but also the
May13, are very expensive. The latter is because it was on-the-run at the time of last
summer’s events. The obvious technicals of government benchmarks illustrate why we
believe it is clearer to use swaps as the benchmark for the purposes of this discussion.
Adjusting for these benchmark effects, the features that remain are slight. Once a 3bp
difference in CDS spreads has been considered, essentially the only feature is the
expensiveness of Treasuries out to the 10yr point. At this point, we do think it is clearer to
switch to expressing this phenomenon as the cheapness of swaps, rather than dearness of
governments. This is generally considered to be due to the US mortgage market. This is
huge. According to the Federal Reserve (end 2003 data), total US Treasury debt outstanding
is $4tn, and home mortgages are $6.8tn, much of which is fixed rate, long-term, prepayable
and securitized. Total corporate debt, by contrast, is $5tn.
The mortgage market leads to large demands being placed on the swap and swaption
markets at those maturities where the mortgage lenders, notably Freddie Mac and Fannie
Mae, are most active, particularly 10yrs and below. Note that “convexity hedging”5 both leads
to swaps paying when rates are rising, and receiving when they are falling, as the probability
of early repayment decreases and increases respectively. However, net, the mortgage market
is a payer of fixed rates. In a rising rate environment, the volatility and borrowing demand
coming from the mortgage market to the swaps market is a major factor in cheapening swaps,
in our view.
We can think of no equivalent in Europe. It follows that the difference in asset-swap spreads
in the US and Europe can, in our view, currently be accounted for by factors which are
independent between the markets.
This shows in the data: Exhibit A is worth a thousand of our words.
4
http://d.research-and-analytics.csfb.com/getdoc.asp?ctbdocid=252428_1_EN&type=.pdf
Again, a full discussion is beyond the scope here and we would refer to the work of our US Mortgage Strategist
Satish Mansukhani.
5
Chart 3 10yr Bund asset swap regressed on 10y UST asset swap. April 2003 April 2004
Securities are rolling on-the-run benchmarks
-70
-60
-50
-40
-30
-20
-10
0
0
-2
-4
-6
-8
-10
y = 0.0831x - 7.5553
2
R = 0.0732
-12
-14
Source: Credit Suisse First Boston
On a one-year scale, there has been no useful correlation between US and German assetswap spreads. The US spike of last summer had a limited effect on the euro area. This is
understandable in light of the fact that it originated in the “convexity trade” described above.
On a longer scale, there is a good correlation (see chart below). In our view, this reflected
fairly extreme moves during the equity boom. Similar extreme moves in future might see a
similar correlation, but we regard the sharp move of the sort seen last summer, in response to
rising rates, as currently more relevant.
Chart 4 10yr Bund asset swaps regressed on 10y UST asset swap. May 1997 April 2004
Securities are rolling on-the-run benchmarks
-140
-120
-100
-80
-60
-40
-20
0
0
-10
-20
-30
y = 0.5689x + 6.1322
2
R = 0.824
-40
-50
-60
-70
-80
Source: Credit Suisse First Boston
As outlined in the ECS referenced above, we are cautious about correlation analysis in asset
swaps: in our view, European swaps have been fundamentally repriced in response to EMU 6.
But the market belief that the curve is a major driver of swap spreads is very strong and is of
clear relevance as the Fed cycle returns.
6
A recap of one argument may be useful here. In our view, European governments are now incentivized to
"arbitrage" their asset-swap curves. For example, a European government confronted with the US's curve, may well
increase issuance at the 10yr point, and receive on swaps. Were the Treasury to do this, it would presumably help
the market equilibrium and narrow the spread.
Chart 5 10yr Bund asset-swap spread and 2s10s government curve. 1998 - date.
0
2
-10
1.5
-20
-30
1
-40
0.5
-50
10yr Bund asset swap spread
-60
-80
Feb-98
0
2s10s German govts (RHS)
-70
-0.5
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Source: Credit Suisse First Boston
Related to this, there is a correlation between Bund asset swaps and the ECB policy rate.
Chart 6 10yr Bund asset-swap spread and ECB policy rate
0
1.5
-10
2
-20
2.5
-30
3
-40
3.5
-50
-60
-70
-80
Feb-98
10yr Bund asset swap spread
4
ECB Repo Rate(RHS, inverted)
4.5
5
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Source: Credit Suisse First Boston
This correlation is better than the correlation to fed funds (chart below).
Chart 7 10yr Bund asset-swap spread and fed funds target
0
0
-10
1
-20
2
-30
3
-40
4
-50
-60
-70
-80
Feb-98
10yr Bund asset swap spread
5
Fed funds target(RHS, inverted)
6
7
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Source: Credit Suisse First Boston
Neither is particularly convincing to us, and we feel that any link to the Fed is likely to be
muted further by the fact that the ECB policy outlook is so different from that for the Fed.
Implications for EIB
The segmentation of the swap spread markets is the major reason for the difference in
funding between USD and EUR, in our opinion. This holds true not only for EIB but for many
other issuers, including some sovereign borrowers such as Italy, Finland and Austria.
Theoretically, there should be no difference in funding levels between USD and EUR after
taking the basis swap into account if there is arbitrage. Yet these differences persist as firstly,
there are too few investors willing to arbitrage the difference because of balance sheet
restrictions, and secondly the issuance patterns are not 'opportunistic' enough. This leaves
both markets driven by domestic factors more often than not, in line with the segmentation of
the two swap spread markets.
Looking at some of the impacts that account for the European developments, in Europe there
are a large selection of often cheaper alternatives to EIB (i.e. swap-related products) including
covered bonds, some of which enjoy better risk-weightings than EIB bonds. One further
impact possibly preventing swap spreads widening together with their US counterparts is the
increased involvement of European Treasuries, most of which are natural receivers in order to
shorten the duration of their debt (France with news out this week (Monday 12 th July) of
possible resumption of swaps programme in H2 and Germany as the two potentially largest
users). Finally, there may be regulatory changes concerning life insurers and/or pension
funds that may have an impact on swap spreads (similar to CP195 in the UK).
In the near future, we expect no major changes to the dynamics of swap spreads both in
Europe and the US, and expect the difference in funding levels to remain. Over the summer,
technicals such as a reduction in government issuance and swapped non-government
issuance, are expected to lead to small seasonal swap spread widening in Europe. In our
opinion, a recovery in Europe with a reaction from the ECB is needed to push government
swap spreads wider from the current narrow trading range. CSFB’s economists expect a 50bp
rate hike by the ECB in Q4 of this year, and therefore we expect the range to be broken only
towards the end of the year.