Authored by Kevin Muir via The Macro Tourist,
This morning I have decided to write about US swap spreads. I know, you are already reaching for the delete key, but wait…
I tried to remember a time when swap spreads were exciting. I dug back into my memory, and tried to recall something that might spice up this snoozer of a topic.
And then it hit me. Swap spreads were one of the positions that bankrupted the fabled 1990’s hedge fund darling, Long Term Capital Management. So I started digging. And I will get to the swap spread portion of the story in a bit, but not until I share with you some other tidbits I stumbled across.
Did you know LTCM marketed themselves as the “Financial Technology Company?”
They actively bragged about their quantitative abilities.
What distinguishes LTCM is our remarkable talent. The quality, background and recognition of our employees is top notch. Our various strategy teams are comprised of a unique combination of specialists in trading, economics, mathematics, and computer science. They include individuals who were the major contributors to the world of finance in the last 25 years and directly involved in the development and application of many of the strategies and products traded in the market today.
The academic and professional backgrounds of LTCM’s Principals and other strategists include faculty positions at major universities, two Nobel Laureates, and service in government, including a former Vice Chairman of the Federal Reserve Board. This distinguished group, many of whom have advanced degrees, have worked together for many years, and have considerable experience in the design and implementation of large-scale trading and financial technology.
Man oh man, that sure sounds familiar to some of today’s quantitative trading darlings. And have a look at the returns of LTCM over the life of their fund.
Look at that steady rise from 1994 to 1998. Remind you of anybody?
I know today’s quantitative gurus will tell you their strategies look nothing like LTCM. And I am sure they are correct. There is no way they will make the same mistakes. Yet I wonder if they will make a whole new set of errors.
Don’t forget, once upon a time everyone was just as confident that LTCM was a new breed of hedge fund that could also do no wrong.
It makes me laugh at how much the original quantitative hedge fund marketing resembles the same narratives we see in today’s market. It’s been a while, but I am going to re-read Roger Lowenstein’s account of the LTCM debacle, When Genius Failed, this summer. And for those that want a good chuckle, I suggest you take a look at Brian Langis’ immortalization of LTCM’s marketing materials. Thanks to Brian we can see the cringe worthy pictures of another age (WTF were they thinking with page 6?). And while you’re at it, give Brian’s other posts a read - it’s an eclectic mix of pieces, but worth following.
Now back to the actual reason for this post - swap spreads. For those who complain that sometimes I get too technical, thanks for reading up to this point. But for those who are interested in maybe finding some more products to trade, soldier on.
In the mid 1990s, one of LTCM’s largest positions was short US swap spreads. Back then swaps traded at higher rates than US treasuries. LTCM viewed the extra basis points that the market demanded due to the perceived credit risk of trading against a bank versus the US government, as unnecessarily high. So LTCM shorted US government bonds and went long swaps. The US year swap spread (the difference between 30 year government rates and equivalent swaps) was trading at 43 basis points. For a while, their trade worked. They earned the extra 43 bps, and in the meantime, spreads began to narrow (like they had predicted). Their short US swap spread position helped contribute to their Madoff like returns. But then the financial world became more unstable.
Next thing they knew, swap spreads were widening. And before the whole debacle was finished, spreads had blown out to previously unheard of wides. It was one of their biggest losses, and their theories were relished to the dustbin.
In the ensuing years, swap spreads narrowed. It took a while, but as Federal Reserve eased in the aftermath of the DotCom bust and the 9/11 tragedy, spreads returned to the levels LTCM had originally shorted.
But as the economy returned to normal, spreads bounced from those low levels, and eventually started climbing. Then as the real estate credit disaster became evident, spreads blew out to new highs. For a brief moment, it looked like we were going to experience another LTCM moment with spreads exploding higher again.
Yet instead of blowing out to new highs in the midst of the great financial crisis, swap spreads did the exact opposite! They collapsed and in the process, did what everyone thought impossible - they went negative.
It made no sense. Why would an investor enter into an agreement with a bank (that might go bankrupt - especially in 2008) for less than the rate on US government treasuries?
Yet the impossible happened.
I have written a few times about this paradox - How many other could never happens are out there? and Only for the bravest and stupidest. No need for me to rehash my theories.
I started getting long swap spreads in October of 2016. Proving once again that you are better off born lucky than smart, I was fortunate enough to bottom tick the 30 year swap spread (don’t worry, I blew all the profits on my disastrous curve steepening call).
I stuck with the position, and in April of 2017, I wrote about some reasons for the widening - The Fed has shifted (and the market has missed it).
And recently, the market is starting to wake up to these arguments. First, banks are feeling more confident under the Trump regime that they will be able to extend balance sheet without being scolded by regulators. Secondly, the idea that the Fed’s balance sheet reduction will source volatility out of the market and cause more mortgaged-backed hedging to move into the swap market might be starting to be priced in. Third, and most importantly, the idea that rates might no longer be headed lower could be slowing down the demand for swaps.
For whatever reason, the swap market anomaly is finally drifting away. Granted, it is a slow drip, but it’s happening.
Bit by bit, the stupidity of negative spreads is disappearing. Now, maybe this piece is about to top tick the swap spread move. After all, I know next to nothing about this space. But it sure seems like a trade that might end up as a surprise win that few are watching.
You are probably wondering how to execute this trade. Well, Goldman rejected my ISDA application, so for mopes like me, we need to stick to the listed futures market.
But don’t let that stop you. It’s quite easy. Dial the two symbols in your Bloomberg terminal, and type PDH2 to get the Position Hedging ratios. Here is the 30 year swap future versus the long bond future calcuation:
If you are like me, and a big fixed income bear, then you don’t even need to worry about the spread. Shorting the swap outright is 30 basis points better than treasuries. If you get a backup in yield, along with a continued widening of swap spreads, it could simply a better product to be outright short.
Although the swap spread has moved over the past year, I think there still might be more to come. Have a look at trading swap futures for a little extra pickup.
P.S.: When I wrote my last piece about swaps, a nice fellow from the ERIS Exchange contacted me to let me know about their competing product to the CME swap future. So far, I have stuck with the CME, but I thought I should include a link to their exchange. Who knows, maybe I should be switching? Let me know if you have an opinion.