The Big Idea

Treasury supply shapes the curve and risk spreads

| November 1, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

If you look at the debt markets these days against an interest rate swap rather than a Treasury curve, the view is very different. Riskless rates run lower and the curve flatter, and credit and MBS trade at much wider spreads. The difference almost certainly reflects the influence of expected US federal deficits stretching to the far horizon and continued heavy Treasury supply. That supply has steadily pushed Treasury yields above swaps. And the prospects of future supply surprises argue that differences are only likely to grow. Asset allocators and risk managers should take note.

Lower rates, a flatter curve, wider risk spreads against swaps

The price of money today is much lower along the swap curve than it is along the Treasury curve, even though both curves represent riskless debt. The swap curve included some credit risk in the days when LIBOR set the rate on the floating leg, but the introduction of SOFR and central clearing of swaps has largely eliminated that. Still, swaps currently yield 23 bp less than Treasuries in 2-year maturities, 38 bp less in 5-year, 52 bp less in 10-year and 85 bp less in 30-year (Exhibit 1).

Exhibit 1: Money costs much less along the swap than the Treasury curve

Source: Bloomberg, Santander US Capital Markets

The difference between the swap and Treasury curves—swap spreads—have been getting greater over time, including this year alone. Rates on 2-year swaps ran nearly 10 bp below rates on 2-year Treasury notes in April this year, for instance, and have since dropped to 22 bp below (Exhibit 2). Rates on 10-year swaps ran nearly 40 bp below rates on 10-year Treasury notes until April and have since dropped to 50 bp below. Something continues to push the curves apart.

Exhibit 2: Both 2- and 10-year swap spreads have tightened since April

Source: Bloomberg, Santander US Capital Markets

Not only are swap rates lower, the curve is persistently flatter. Swaps 2s10s, for example, runs persistently flatter than Treasury 2s10s (Exhibit 3). Today swap 2s10s shows a negative 17 bp slope while Treasury 2s10s shows a positive 11 bp.

Exhibit 3: The swap 2s10s is consistently flatter than the Treasury 2s10s

Source: Bloomberg, Santander US Capital Markets

And with a growing difference between swaps and Treasuries, benchmarking risk assets to the swap instead of the Treasury curve also tells a different story. The OAS to the Treasury curve on the Bloomberg investment grade corporate index lately stands at 81 bp, tighter than all of sessions of the last five years. But the OAS to the swaps curve comes out at 127 bp, tighter than only 60% of sessions in the last five years (Exhibit 4). Credit looks rich to Treasuries, slightly rich to fair against swaps.

Exhibit 4: Investment grade credit looks rich to the Treasury curve, fair to swaps

Source: Bloomberg, Santander US Capital Markets

Finally, MBS. That also looks different depending on the benchmark curve. MBS recently has widened to both the Treasury and swap curve, but especially to swaps. At 53 bp wide to the Treasury curve, par 30-year MBS is wider than 84% of sessions in the last five years. At 96 bp wide to swaps, the par coupon is wider than 94% of sessions in the last five years (Exhibit 5).

Exhibit 5: MBS has widened to both curves, but especially to swaps

Source: Bloomberg, Santander US Capital Markets

Driving the spread between swap and Treasury yields

Swap spreads have long reflected differences between swap and Treasury dynamics, but actual and expected Treasury supply is clearly one of them. After all, the spread itself is nothing more than the yield difference between the markets:

  • The swap rate where one party is willing to receive a fixed rate for, say, 10 years, in exchange for paying a floating or cash rate, and
  • The Treasury rate where one party is willing to exchange cash for a 10-year security

Although both sides of the spread should equally reflect Fed policy and expected inflation along with real rates and term premiums, the Treasury side is especially affected by supply. Treasury supply depends entirely on US fiscal policy and federal deficits, while supply in swaps is effectively infinite and discretionary since hundreds of thousand of parties worldwide at any time can agree to pay a fixed rate in exchange for a floating one. Work by the Treasury Borrowing Advisory Committee and the World Bank, among others, also shows a longstanding and material impact of Treasury supply

The historical picture of impact from Treasury supply is clear. In the late 1990s, for example, the US ran a fiscal surplus around 2% of GDP and the outstanding supply of Treasury debt fell. With Treasuries in short supply, Treasury yields fell relative to swaps and spread between 10-year swaps and 10-year Treasury debt approached 140 bp (Exhibit 6).  At the other extreme, the US deficit approached 10% during the Global Financial Crisis in the late 2000s. With Treasury debt flooding the market, Treasury yields rose relative to swaps. The spread collapsed toward 0 bp.

Exhibit 6: Swings in US deficits and Treasury supply affect swap spreads

Source: Bloomberg, Santander US Capital Markets.

The growing difference between swap and Treasury yields since 2022 also is likely due to expectations of increasing US deficits and Treasury supply. Explicit measures of supply years ahead—the thing that market pricing should anticipate—are hard to come by. But the Congressional Budget Office routinely projects federal deficits for the next 10 years. Taking projections of 1-year ahead deficits as a benchmark, deficit expectations have grown steadily since mid-2022, going from 4.2% in May 2022 to 6.7% in June this year, consistent with a relative rise in Treasury yields. Promises during current campaigns from Democrats for more US spending and from Republications of extending current tax cuts and adding more may explain the notable tightening of spreads in just the last two months.

Other things affect swap spreads, too, but most of them have little impact in today’s market:

  • Credit. This mattered when the floating index in swaps, LIBOR, depended on rates set by London banks for Eurodollar deposits. But the switch to SOFR, a riskless rate, and the central clearing of most swaps has eliminated credit exposure.
  • Treasury repo. When swap dealers hedge interest rate exposure, they usually use either long or short positions in Treasury debt or in Treasury futures, the net carry on both reflecting Treasury repo rates. If repo is unusually high or low, it affects net carry in the hedged position and, consequently, swap spreads. The spread between Treasury general collateral repo and SOFR has been relatively stable this year, eliminating this factor as an influence on recent spreads.
  • Yield curve slope. Positively sloped curves generally encourage more demand to receive the fixed swap rate, lowering the swap yield and tightening spreads. But the swap curve today is still inverted from SOFR out to the 10-year swap rate, and changes this year in the slope of the curve are uncorrelated with spreads.
  • Mortgage hedging. Mortgage portfolios tend to receive fixed as interest rates drop and pay fixed as interest rates rise, moving swap spreads along the way. But mortgage hedging currently is at a very low level.

Asset allocation and risk management implications

With the odds good for more supply surprises after US elections, especially if one party controls all branches of government, Treasury yields should keep rising relative to swaps. That has some implications for asset allocation and risk management:

  • Credit especially should outperform Treasury debt, with spreads taking a run at record lows against the curve, even while credit performs roughly in line with swaps. Mutual funds and other portfolios benchmarked to indices with material Treasury exposure should overallocate to credit and underallocate to Treasury risk.
  • Portfolios managing risk assets can pick up significant carry by moving hedges from short positions in Treasuries or Treasury futures and into SOFR swaps or swap futures. Hedge funds or mortgage REITs especially could benefit from this, with the extra spread multiplied by fund or REIT leverage. Alternatively, the fund or REIT could use the extra spread to deleverage and still hit target return on equity.
  • Debt issuers managing rate and spread risk can choose to pay fixed in SOFR swaps instead of using Treasury instruments, lowering the cost of managing the risk

* * *

The view in rates

The rise in rates through October is starting to make things more interesting. The market seems to believe that elevated risk of federal deficits and an inflationary impact from tariffs justify the yields. The impact of tariffs could nudge up inflation, but the Fed would likely respond to bring long-term inflation back to target. The flattening of the curve makes sense, but the level of rates—especially at longer maturities—does not, at least in the long run. Longer rates look attractive at current yields

Other key market levels:

  • Fed RRP balances closed Friday at $155 billion, down $72 billion in the last week. Since the Fed dropped policy rates by 50 bp on September 18 and set the RRP rate at 4.80%, balances initially jumped as T-bill yields dropped well below RRP yields. But in the last few weeks repo rates for general Treasury and MBS collateral have far exceed RRP, drawing balances away from the Fed facility.
  • Setting on 3-month term SOFR closed Friday at 455 bp, down 5 bp on the week.
  • Further out the curve, the 2-year note closed Friday at 4.21%, up 11 bp in the last week. The 10-year note closed at 4.38%, up 14 bp in the last week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at 17 bp, steeper by 4 bp in the last week. The 5s30s closed Friday at 35 bp, flatter by 8 bp over the same period
  • Breakeven 10-year inflation traded Friday at 234 bp, up 5 bp in the last week. The 10-year real rate finished the week at 205 bp, up 10 bp over the last week.

The view in spreads

Implied rate volatility continues to reach new highs for the year. Investors are primarily questioning the pace of Fed easing, although election concerns get airtime, too. That is a marginal negative for spreads in risk assets. The Bloomberg US investment grade corporate bond index OAS nevertheless closed Friday at 84 bp, wider by only 2 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 149 bp, tighter by5 bp for the week. Par 30-year MBS TOAS closed Friday at 52 bp, tighter by 1 bp over the last week.

The view in credit

Fundamentals for consumer and corporate credit still look relatively good. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Unemployment has held steady, and high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months. Commercial office real estate looks weak along with its mortgage debt.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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