Manager Writes: Swap Spreads

Has the time come?

Stephane Priaulet, Fixed Income Strategist, AXA Investment Managers

Since the beginning of the year, credit spreads have been rising pretty much across the board. Several factors are at work: persistent inflation fears, uncertainties over how much monetary tightening (Fed, ECB) is required given the current economic environment, and the combination of falling stock prices and higher volatility. Among the various credit spreads, swap spreads have undergone the sharpest correction, adjusted for volatility, to the point where their valuation has become attractive. But does this mean that the rise in spreads is over?

Attractive valuations

Compared with Investment Grade (IG) and High Yield (HY) spreads, swap spreads have risen rather substantially since the beginning of 2005, whether in the United States, Euroland or the United Kingdom. As a result, they have returned to their 2002 levels, while IG and HY spreads are at their year-end 2004 levels.

The contrast is the most marked in the United States. During the 2005-2006 period, the average monthly widening in swap spreads, adjusted for risk (0.41), was three times that of IG spreads (0.14).

To our mind, swap spreads look today either cheap (United States) or close to their fair value (Euroland), based on the following drivers: the slope of the yield curve; volatility, as measured by the risk premium between BBB- and AAA-rated debts; and the duration of portfolios of mortgage-backed securities (MBS).

Having said this, have the risks of wider spreads totally disappeared? In our opinion, they revolve around the outlook for monetary policy, yield curves, market volatility and fiscal policies.

The risk related to monetary policies

Historically, swap spreads tend to widen during the final phase of a monetary tightening cycle, before reversing trend. As a matter of fact, in the US, when the Fed raised its key rates from 5.5% to 6% in 1995, swap spreads increased by 3bps. In 2000, when Fed Fund rates went up from 6% to 6.5%, they increased by 10bps. Consequently, the trend in US swap spreads will be dependent on the Fed policy. If, as we believe, the Fed stops its policy tightening at 5.5% in August, swap spreads should stabilise and then begin to fall. However, it could be that uncertainties surrounding US monetary policy will continue to exercise moderate upside pressure on them. In the Euro area, the situation seems even clearer, to the extent that the ECB is only halfway through its repo rate hike cycle. During the second phase of the last tightening cycle, in 1999-2000, swap spreads widened by 23bps. They should continue to do so this time.

The risk related to yield curves

Usually, swap spreads are negatively correlated with the slope of the yield curve. This relationship, while it is not being called into question, has weakened substantially in the course of the last two years, primarily due to carry trade opportunities that investors have been able to exploit in a context of historically very accommodative monetary environment.

However, as monetary policy becomes tighter, carry trade opportunities are being eroded. Consequently, the slope of the yield curve should regain some influence. In the United States, the moderate inversion (10bps) of the 210 year slope that we are predicting should have a relatively small impact on swap spreads. In the Euro area, the 40bp flattening of the yield curve we are anticipating should carry more weight.

The risk related to market volatility

Since May, equity market volatility has increased significantly (the VIX has gone up from 12 to 18, and the VDAX from 14 to 22) and has become more erratic. It could continue to climb under the influence of negative surprises on inflation, growth and monetary tightening. In this case, the impact on risk premia, swap spreads in particular, would clearly be to the upside.

The risk related to fiscal policy

In the Euro area, the combined impact of growth revival and greater fiscal discipline, particularly in Germany and Italy, bodes well for an improvement in public deficits. This could lead to a decline in the supply of government bonds relative to corporate issuance, which could in turn favour government yields to the detriment of swap spreads.

Conclusions

Today, swap spreads seem to be either cheap (in the US) or close to their fair value (in the Euro area), on the basis of our valuation model. However, we should not overlook the risk of further widening of these spreads. First of all, historically, phases of monetary tightening have coincided with wider swap spreads. The recent period is no exception, even though the correction was much less severe due to the unprecedented abundance of liquidity. In addition, the current climate of uncertainty surrounding the degree of monetary tightening to come should continue to support a moderate increase in spreads.

Further flattening/inversion of yield curves also argues in favour of an extension of the upward drift in spreads, notably in Euroland. The expected improvement in public deficits in the Euro area is yet another argument.

Overall, despite the attractive valuation levels, we still think it is somewhat premature to revisit swap spreads. The conclusions of the next FOMC meeting in early August should remove some of the uncertainty, if it leans toward an end to the current tightening cycle.