Originally published by Commonwealth Bank of Australia
Aussie swap spreads have lifted from their tightest levels in decades. Spreads remain in a tight range, but lifted after Trump’s election win amid improved demand for bonds and less domestic supply.
That tone softened in May and swap spreads re‑tightened amid a crunch in LIBOR spreads, as impact of prior reforms faded.
The next major headwind looks to be an unwind of the Fed’s balance sheet, which should put pressure back on bonds and further tighten swap spreads. A complication could be that the unwind also puts pressure back on money market spreads. But the impact on swap can be sporadic and we’d expect it to be less than the direct impact on Treasuries.
Improvement in Australia’s Budget fundamentals suggests the local market is better placed than in 2015 to withstand tightening US swap spreads. But that still looks the greater risk (assuming US politics does not totally break down).
With infrastructure deals out of the way, we see more room for long swap spreads to compress than the front end.
Chart 1 shows that AUD swap spreads remain around historic lows. But the 10yr spread has recently widened in line with US moves amid the Trump reflation (and perhaps deregulation) trade. With the 3yr spread relatively stable, this has taken the AUD 3s10s ‘box’ back into a positive 8‑14bp range following the plunge into negative territory in 2015‑16. The 20yr spread, for all its illiquid shortcomings, has also turned positive (just).
Swap spreads are trading in a low, tight range for a variety of reasons. It reflects the move to central clearing and other measures to de‑risk the swap market, breaking a nexus between swap and bank credit spreads. Bond buying by central banks has also waned, forcing a cheapening of Treasuries relative to swap. Australia certainly didn’t prove immune to this amid the ramp‑up and lengthening of government bond issuance (ACGBs).
Australia’s new long bonds started life very cheap to swap. But the new 30yr ACGB in Oct‑16 marked the bottom for swap spreads (or peak on ASW basis in Figure 2), before a broader turn emerged after Trump’s surprise win. Supply takes time to fuel demand, but the cheapness in the bonds did appeal to investors and they have subsequently richened to swap. Large scale 5yr and 12yr ACGB issuance in January and February took bond supply risk out of the market, so ACGBs have had little trouble matching the tightening (dis‑inversion) of US swap spreads over recent months.
Swap liquidity is light (to use a gentle euphemism) beyond 10yrs, and corporate (infrastructure) paying has contributed to lifting the swap rate. The 20yr swap rate is 90bp off Brexit lows, whereas the 20yr ACGB is up 75bp.
Figures 1 & 2 show there has been a small reversion again in May. That was initially more acute in the AUD market, but the good news for bonds in the Budget has subsequently reversed that. Looking ahead, we think the fundamental domestic issuance story points to wider swap spreads. But, as often the case, US moves are having a larger impact.
Part of the most recent tightening of swap spreads reflects a crunch tighter in USD LIBOR. An unwind of the 2016 squeeze in US money markets turned into a rout exacerbated by wrong positioning, which filtered along the curve. With the money market looking more stable in recent days, we don’t see a lot of room for this to extend further. But we do think start of the unwind of the Fed’s QE program later in the year should put pressure on bonds, helping US swap spreads tighten back toward range lows. With infrastructure deals out of the way, we see more room for long swap spreads to compress than the front end.
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