Euro swap spreads spiked earlier this year to historic wides, with the 10-year spread rising 60 basis points (b.p.) to an intraday peak of 108 b.p. on October 11. The spread indicates the gap between the euro interest-rate curve and the yield on equivalent-maturity German government Bunds. Today, moves in swap spreads are mostly influenced by technical factors such as the supply of collateral (i.e., Bunds) in the market and demand for swaps.
There have been several reasons for the recent swap-spread widening, principally:
- a shortage of collateral, as the bond-buying programs of the European Central Bank (ECB) have reduced the Bunds available to the market
- high demand for swaps from banks and other investors, as swaps can be used to put on sizeable positions to short euro interest-rate risk across the curve in anticipation of rising European yields
Since the peak in swap spreads, we have seen a 20 b.p. tightening in less than two weeks. Is this the start of a larger correction? We think so, as we see the drivers of wider spreads reversing over the coming months.
Drivers of Wider Spreads Poised to Reverse
Recently, the German Finance Agency announced that €54 billion of their own Bund holdings will be made available for repos (repurchase agreements), thus alleviating some of the shortage of collateral.
Meanwhile, euro-area governments’ fuel subsidies—including Germany’s €200 billion support package—are boosting fiscal deficits and increasing the supply of sovereign bonds.
Further, the ECB has ended its quantitative easing bond-buying programs and has been reinvesting in fewer Bunds than have been maturing, and it may begin quantitative tightening next year. These factors should increase the supply of Bunds in the market.
At the same time, the current demand for swaps will likely fall. Banks and other investors have been selling the fixed-rate component of swaps and buying the floating component to short euro interest-rate risk. Now, as the ECB fights to bring inflation back to target, risks of a sharper downturn in the eurozone are rising, and the probability of steep euro rate rises is falling. This dynamic is likely to reduce demand for these euro swap positions.
Shifts in Swap Spreads Determine Credit Pricing
Many investors value euro investment-grade credit bonds against the swap curve. As a result, these bonds cheapened against Bunds as swap spreads widened over the last year. Tighter swap spreads would likely make euro corporate bonds increase in value relative to equivalent US dollar-denominated bonds, which aren’t experiencing such powerful drivers.
In our analysis, investors may want to consider ways in which to take advantage of a potential tightening in swap spreads.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.