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Market pukes have a fun habit of revealing weird things in the financial diet. We saw a great example of this earlier this month, when the upheaval caused by the Trump administration caused some serious indigestion with bets on “swap spreads”.
Alphaville and MainFT have written a decent amount about the subject already, but here’s a quick (ish) recap of the trade that seemed to play an outsized role in the Treasury market’s April mayhem.
Tougher regulations made it harder for banks to hold lots of assets, even US Treasuries. That led to a weird phenomenon: the fixed rate leg of an interest rate swap started trading at a lower yield than comparable Treasuries. In other words, swap spreads were negative.
Earlier this year, investors became excited about the prospect of bank deregulation from the Trump administration — specifically the potential scrapping of the “supplementary leverage ratio”. The theory was that this would free up banks and end the negative swap spread. But when Treasuries were rattled in early April, swap spreads instead widened, causing carnage among investors who had bet on them narrowing.
Barclays analysts were among those who held a “constructive stance” on swap spreads, and were subsequently wrongfooted when ~cough~ “macro developments posed significant headwinds to swap spread performance”, as they put it.
But they now think the time has come to reload those swap spread bets. From a note published this morning:
We revisit our spread widener bias and recommend buying 3y swap spreads. Market volatility has subsided and the administration appears to be softening their stance on tariffs. Potential SLR reform, an attractive carry-adjusted profile, and recent bank buying of USTs should support spreads.
As you can see, the rationale is much the same as before. The tweaking or scrapping of the supplementary leverage ratio is still expected, and should free up a lot of bank balance sheet capacity and cause swap spreads to narrow again.
And now that the bond market has calmed down a little, this is the time to get back into the action, Barclays’ analysts reckon. Here are their main points:
. . . Supplementary leverage ratio (SLR): The recent moves in swap spreads could potentially prompt regulators to pull forward action on SLR reform, if only an earlier announcement, with actual implementation at a later date. An interim solution to address potential Treasury market turmoil by temporarily exempting USTs and bank reserves from SLR would be viewed as a positive for spreads. We continue to believe that SLR relief is likely to benefit the belly of the spread curve, where banks prefer to own Treasuries. We think banks remain averse to long-end spreads give their performance under historical stress scenarios, such as was the case during COVID, 2022 UK LDI crisis, and the recent post-Liberation day tightening.
. . . Calmer markets and lower volatility: The bond market rout has eased and risk sentiment has improved in recent weeks. The Trump administration appears to have softened their stance on tariffs and is looking to deescalate tensions with China. President Trump’s actions reveal a preference for keeping long-term yields in check. With the worst potentially behind us, this should provide some support for risk assets and stability for swap spreads, though trade negotiations could take time and the outcome is still uncertain.
. . . Liquidity conditions and funding: Treasury liquidity conditions have been orderly and there have been no signs of pronounced stress or dislocations in the market aside from the moves in swap spreads. Relative value metrics such as errors to the Treasury spline increased modestly, but remain benign. There were some concerns that foreign investors were behind the aggressive selling in USTs. We do not see evidence of this in the data that have been reported in recent weeks.
That all seems reasonable enough, and there are legitimate reasons for why the SLR should at least be modified — such as exempting Treasuries from its calculation, as they were at the peak of the March 2020 mayhem. But a de facto bet on calmer, more measured policymaking from the Trump administration still seems a bit dicey.