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Extraordinary Doings in the Bond Market

Negative Interest Rates

To go along with the piece I wrote earlier today (here), the bond market appears to have picked up on the theme of deflation. The 30-year US Treasury bond rocketed upward in price to more than 118 and a half by today’s market close, and much of the move came late in the day.

This price corresponds to an interest-rate of 3.49% for the long bond. Just this morning, it was trading to yield over 3.90%. For the bond to drop over 40 basis points of yield in a single day is simply unheard of.

If this pricing holds up (and bond yields have been exceptionally volatile for many months now), it indicates at the very least that there is now an expectation that inflation will be non-existent for years into the future.

But I don’t think that’s the whole picture here.

There’s an arcane interest rate called a “swap spread.” It’s a way of pricing plain vanilla interest-rate swaps (the kind where you receive a fixed rate of interest for some period of time on a nominal amount of money, and in return you pay a floating rate, perhaps 6-month LIBOR).

You can think of a swap as roughly equivalent to purchasing a fixed-income security with short-term borrowed money. So it’s useful to compare the fixed swap rate on any given day with the US Treasury rate, at the corresponding point on the yield curve.

And that gives you an interest rate measured in basis points that is generally taken to indicate the credit risk of a typical AA-rated bank. (Since such banks are often the ones who pay on swaps.)

The 30-year swap spread (meaning, the difference in the interest rate on a 30-year swap and a 30-year Treasury bond) has been running slightly below zero for several days now. The swap, in other words, is priced as if it were more valuable than the bond.

This is senseless (and in fact has long been considered mathematically impossible) because a swap has credit risk and a Treasury bond doesn’t. Can you imagine borrowing money, and having the lender pay you interest instead of the other way around? And besides, wouldn’t you guess that someone will always find a way to arbitrage away a negative interest rate?

Negative interest rates are very occasionally seen in overnight repo, depending on the collateral, in times of severe stress. But not in swap.

Today, however, the 30-year spread got even more negative. In fact, it plunged all the way to NEGATIVE 60 basis points, according to some reports. This is almost as surprising as a shattered window pane jumping back together by itself.

The only way this can be possible, that I can imagine anyway, is if large numbers of investors are being forced to liquidate positions, for some reason. It’s known that fixed-income professionals use all kinds of arcane mathematical strategies to trade the shape of the yield curve. Something must be happening to make a lot of those trades go bad all at once. And something must be forcing lots of people to get liquid at once, even if they have to take extraordinary mispricings to do it.

And that tells me that we’re witnessing a temporary, short-lived effect. But it’s like a major volcanic eruption, or a nine-magnitude earthquake. It won’t last for a very long time, but it will produce a completely unpredictable amount of lasting damage. We’re likely to see wild swings in all markets, in both directions, over the next few days and weeks until this washes out.

Pass the popcorn, everyone. We’re witnessing history being made.

-Francis Cianfrocca

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