Some Signs of a Thaw in the Credit Freeze

It is way to early to take cheer, but some of the stress in the money markets is backing off a bit. The TED spread is below 4, and ten year credit swap spreads were down to 45 basis points, which is a serious improvement and a genuine positive sign. From Bloomberg:
The spread between the rate on 10- year interest-rate swaps and Treasury yields collapsed to the least since before credit

markets began to seize last year after coordinated central bank rate cuts.

The spread narrowed to as low as 44.94 basis points, the smallest since Feb. 6, 2007. The differences, or gaps, between swap rates of most maturities over corresponding Treasury yields are down today. The 10-year swap spread was 52.25 basis points at 3:06 p.m. A basis point is 0.01 percentage point.

“The movement in the 10-year swap spread is signaling a break in the upward trend in credit spreads,” said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York. The movement “is probably hinting at a drop in the two-year swap spread, which if it occurs would strongly signal an easing of pressures in the inter-bank market.”

Two-year swap spreads are often used as a gauge of credit concern and near-term expectations for the London interbank offered rate, or Libor. The two-year swap spread is down almost 1 basis points to 133 basis points. It reached 167.25 basis points on Oct. 2, the widest since Bloomberg began compiling the data in 1988.

Swap rates serve as benchmarks for investors in many types of debt often purchased with borrowed money, including mortgage- backed securities and auto-loan securities. Narrower swap spreads can push borrowing costs lower even if Treasury yields are steady.

However, a big offset that might rattle some nerves is how badly today’s Treasury bond sales went, per John Jansen. The result appears in large measure due to Treasury clumsiness, but this market is not in the mood to hear more bad news:

The auction of the May 2015 issue was an amazing occurrence. The Treasury gave the dealer community about an hour to underwrite $10 billion of supply. That was a big mistake. I always kid that in the underwriting process it is the job of the dealer community to shoot the taxpayer in the big toe. In this instance they amputated a leg instead.

Let me explain. There once was an active and deep market for off the run Treasury paper. An off the run is an issue offered by the Treasury at another time which has now rolled down the yield curve. Several of these issues mature in about 6 years. They were originally sold as 10 year notes. They have lost on the run status and qualify as off the run.

So the first issue in the queue was the May 2015 issue. Unfortunately, I do not have precise yield levels but will try and back into the answer. The auction average was 3.31 percent. I am told by participants that the 3.31 percent yield was 40 basis points cheap to the level which prevailed in the market prior to the auction. The point is that in order to rustle up the $10 billion of bids to clear the $10 billion auction the Treasury had to reach 40 basis points from market levels.

In bond market jargon that 40 basis points is known as a “tail” or the number of basis points from where the issue was to the level at which it stopped. Most auctions come “on the screws” which is more jargon for the notion that they come essentially where they are trading at auction times. A typical “sloppy” auction might “tail” 2 basis points. There are 5 basis point tails and I can recall 10 basis points and even 15 basis point tails. They are rare. Extremely. In all my years I can not recall a 40 basis point tail and shall proclaim this the record holder.

Now to place that in dollars and sense terms for the taxpayers of the USA I offer this. On that bond every basis point is worth a little more than $600 per million bonds. Multiply by 40 basis points and you get $24,000 per million. The auction size of $10 billion equates to 10000 million. Multiply by 24,000 and the product is $240,000,000.

In a market to market sense it cost the taxpayers that enormous sum to underwrite the auction today.

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  1. a

    According to my bank’s USD guy, no offers for USD today in the market. None. Maybe he’s just saying that to keep me from getting pissed off at him, but that’s what he said.

  2. Anonymous

    The Bloomberg article also has this quote about the 10-year swap, which makes me even less likely to cheer this news:

    “The abrupt movements today are likely due to hedging- related activity by exotics trading desks due to the flattening of the spread between the 30-year and 10-year swap rate,” Liverance said. “This is a phenomenon that has happened before and I would not read any credit related issues into it.”

  3. David Merkel

    Yves, you might also look at what Jansen said on the long end of the swap curve:

    There is some interesting stuff playing out in the 30 year sector of the swap curve. There has been chunky receiving in the 30 year sector by pension fund accounts that need duration. Separately, there were certain trades in exotic derivatives, which have gone sour, and has necessitated receiving in the 30 year sector by options desks hedging flattening exposure.

    That would pull the 10-year swap along with it. I like Tony, but I don’t think he is right here. He is more of a money markets/ governments guy, not a corporates guy.

  4. Anonymous

    Take a look at the closing comments by Jansen. He has a readers view on the Treasury sale today that contends the Treasury was trying to punish those hoarding richly priced bonds. Jansen doesn’t seem to buy the notion but it is an interesting alternative take on the deal.

  5. Anonymous

    a, liquidity trap, or anyone else that knows a lot about investing,

    Which mutual funds do you think are as FPA funds in terms of willingness to hold cash, focus on absolute return, patience to wait for prices to fall to buy targets, willingness to sell as prices rise close to sell targets, etc.?

    I love reading you guys/gals comments, and would love your thoughts.

    Much appreciated,

    Dumb Money Retail Investor
    (cash and TIPs since mid 2006)

  6. Anonymous

    1) UST reopened the 2015 sector because it was "squeezed" so trading a lot of bps expensive to "fair value". 40bp was the tail, but the average price makes more sense. Treasury may have wanted to punish squeezes & prevent market manipulation.

    2) not only USTs are underperforming swaps, but the trend is set on all govt bonds now.
    they were perceived as safe have and have been rallying strongly for a year, thanks to the crisis, and to the Funding squeeze. But these factors are fading now with much more supply coming (for the bailouts and because of the recession), and CB intervention which will become effective at some point, as they throw everything.
    but youre right, mkts are becoming more and more illiquid, and execution cost for big trades / auctions / any unwinding going up a lot, and causing volatility.

    4) the ultimate step in the financial crisis would be for some govt auctions to fail. Iceland, but at a bigger scale.

    5) for that to happen in the US, contrarily to the common opinion, i dont think it would come from the Chinese, Japanese etc… to capitulate on their USD, but it would take the loss of trust by American themselves instead, which would take out all their cash and open accounts oversease….flight of capital

  7. Matt Dubuque

    Michael McKenzie of the Financial Times, very well connected to the RP markets, states that today’s panicked auction by the Treasury was due to the extremely serious “RP fails” that have been occurring at the very heart of the financial system.

    When these were first revealed about 10 days ago, I mentioned in this blog that this was an extraordinarily serious development. This is a very big deal.

    In fact it was taken so seriously that Paulson doesn’t care about a whopping 40 bp just to try to fix it….

    I quote McKenzie:

    “Investors have stopped lending cash to banks even in return for collateral such as US Treasuries. That has broken the chain of lending between numerous banks to such an extent that borrowed securities have not been returned.
    These so-called “repo fails” prompted the US Treasury on Wednesday to re-open various Treasury issues and sell more debt. A greater supply of Treasuries could improve lending in the repo market over the next few days, said traders.”

    Matt Dubuque

  8. bg

    I hesitate to step into such a wonkish discussion, but I spent the last couple of hours trying to track the cause of the TED spread improving, and the supporting headline optimism from Yves. I got no-where. But I hardly think that falling below 4 is so important, any more than saying a forest fire is improving because the temperature fell below 500C.

    Whoever is trading on the money markets is at the margins, and not representative of the core (which is not trading at all).

    When we globally nationalize the banks, and these banks start lending to others in the nationalized club, then we will be able to breath again.

  9. Richard Kline

    So Matt, RP fails get a *YIKES* even from me. It’s one [very bad] thing for financial firms not to trade with each other, but when they _break their contracts_ with each other it’s a ‘Nazis leaving Berlin’ kind of moment.

    It would make a difference to know who’s failing whom. For example, it seems we are clearly approaching nationalizations for some especially rotten banks; if their swapees are holding onto the goods in anticipation of an event of failure, perhaps there’s logic in the mayhem. Seems to me Lehman had stuff out on loan that wasn’t given back when it went *boink*. Then too, I would hope it’s a technical snafu. However you slice ‘n’ dice it, though, This Is Bad.

  10. melpol

    The government is now giving away the treasury to banks in the hope that they will have more to lend the borrower. That is a great way to stimulate the economy as long as the banks make all of the potential borrowers eligible for a big fat loan. The only problem is that the banks will go bust again when most of the big fat loans are not repaid. But the problem will be solved when Uncle Sam comes to the rescue and bails out the banks for a second time. There must have been an economic genuis that devised this theory to keep us all happy. It is deserving of a Nobel Prize.

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