Three Reasons For Extremely Low Swap Spreads

US swap spreads continue to decline, as the 5-year spread hovers below 10bp. A rate swaps is basically a stream of floating (3m LIBOR) vs. fixed payments. The level at which fixed payments are set (the swap rate) is therefore the market's projection of future LIBOR. This decline in spread is the market's expectation that future LIBOR to treasury spreads will be lower. Three factors are contributing to this decline:

1. With the ECB backstop to the eurozone sovereigns in place, the perceived risks to global banks have subsided. Improved health of the global financial system means lower cost of funding for banks, which should (loosely) translate into lower LIBOR to treasury (TED) spread in the future - thus lower swap spread.

2. As LIBOR converges to CD rates (see discussion), which have generally been lower, the market is pricing in lower overall LIBOR levels in the future (reducing swap spreads).

3. The Fed has been taking duration out of the market, first via Twist (see discussion on how Twist reduced duration) and now also with MBS purchases (see discussion). With mortgage refinancing accelerating, MBS durations decline. When fixed income investors hedge against rate risk, they usually want to pay fixed and receive floating on a rate swap. But as the need to hedge fixed income portfolios declines (because portfolios have lower durations) so does the demand to pay fixed - which reduces swap rates and spreads.

If anything, investors now want to receive fixed on rate swaps to synthetically increase their portfolio durations. An example of that may be a life insurance company that has long-term liabilities (death benefits) and needs long-term assets to avoid a duration mismatch.

Note that the bump in swap spreads during the May-June period was all driven by the eurozone, as LIBOR to Treasurys spread widened and so did swap spreads. A change to any of the three factors above (like the May-June period) could reverse this trend. For now however the ECB, the Fed, and new LIBOR regulation should keep swaps spreads low.