Market distortion sparks debate on gov’t debt

by 17 Nov 2015
Across developed markets, the conventional relationship between government debt – long considered the risk-free benchmark – and other assets has been turned upside-down.

Nowhere is that more evident than here at home, where lending to the government should be far safer than speculating on the direction of interest rates with Wall Street banks. But these days, it’s just the opposite, as a growing number of Treasuries yield more than interest-rate swaps.

With China poised to cull its U.S. debt holdings for the first time since 2001, the decline in demand is contributing to higher borrowing costs. Yields on 10-year Treasuries have climbed from a low of 1.90% on Oct. 2 to 2.26 percent as of 7:26 a.m. Monday in New York.

JPMorgan Chase & Co. estimates the U.S. government may face $260 billion in additional interest costs over the next decade as a consequence.

“This is not really just a somewhat esoteric story about interest-rate derivatives,” strategists led by Joshua Younger wrote in a Nov. 6 report. “Moves in spreads should be viewed as symptomatic of deeper problems.”

Another potential problem is that inverted swap spreads may ultimately cause investors and borrowers to lose confidence in the bond market’s ability to correctly price risk and provide capital to those who need it, according to Steve Major, head of fixed income research at HSBC Holdings Plc.

Demand for swaps, which has boomed in recent years as companies that issued fixed-rate bonds used the contracts to hedge away the risk of changing Treasury yields, also serve as benchmarks for a variety of debt, including mortgage-backed and auto-loan securities.

“The role of the bond market is to provide funding at the right rates for the real economy,” said Major. “That’s why the bond market exists – to help efficiently finance projects, businesses etcetera. If that efficiency is undermined, it’s not going to be a positive thing for the economy.”
Whatever the reason, the severity of the distortions is unnerving many investors.

“What there doesn’t appear to be is any single smoking gun that says why swap spread changes have been so dramatic,” said Thomas Urano, a money manager at Sage Advisory Services Ltd., which oversees $11 billion. The big question remains whether there is “something bigger brewing under the surface that so far hasn’t been pinpointed yet.”



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