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Long-dated Treasury yields slid and shorter dated notes rose as the yield curve flattened on Tuesday, while a dramatic move in a key US interest rate relationship began to stall.
Benchmark 10-year Treasuries edged 2 basis points lower to 2.39 per cent, while 30-year bonds slid 7 basis points from their peak in the New York morning, finishing the day at 3.01 per cent. Shorter-dated 2-year Treasuries finished 1 basis point higher at 1.17 per cent.
Financial stocks, which are thought to benefit from a steeper yield curve, fell 0.2 per cent, adding a second day of losses and eroding Friday’s gains from the new administration’s announcement of a review of financial regulation. Investors remained cautious as political wrangling continued for President Donald Trump, this time directed toward Betsy DeVos, his pick for education secretary, who was narrowly confirmed by the Senate after vice-president Mike Pence cast the first ever tie-breaking vote in a cabinet confirmation.
“This represents a level of opposition to Trump’s administration that the market assumed we wouldn’t see for at least a few months,” said Ian Lyngen at BMO Capital Markets. “It might arguably be a bit early to say that the ‘honeymoon is over’, but this level of opposition to the education secretary doesn’t bode well for the prospects of getting through some of Trump’s less popular agenda items.”
Also on Tuesday, a dramatic move in the difference between US Treasury yields and the fixed rate of an interest rate swap took a breather. Historically, interest-rate swaps had higher rates than Treasury yields, reflecting the supposedly risk-free status of the US government. That relationship has become inverted since the financial crisis, but the 10-year “swap spread” has come close to moving back into positive territory in recent weeks, having turned negative in September 2015.
The 10-year swap spread has moved from -18 basis points on November 24 to -6.75 basis points on Tuesday – the closest it has been to normalising above zero since the end of 2015.
JP Morgan analysts attribute the movement to the unwinding of swaps put on by insurance companies as interest rates tumbled after the financial crisis. As interest rates fell, insurers used derivatives to continue paying the declining floating rate but recieve a higher fixed rate – this is the “swapping” of rates that gives the contract its name. As Treasury yields have risen sharply since the US election, insurance companies have begun unwinding some of those positions, wanting to lock in paying a low fixed rate and recieve the upward trending floating rate.
“The reason for the recent move is variable annuity hedging from insurance companies has been reversing,” says Josh Younger, derivatives strategist at JP Morgan. “It’s a big unwind trade from the insurance community.”
Citi analysts also point to other investors looking to hedge against rising interest rates, and lock in paying a low fixed rate, as contributing to the shift in swap spreads.
The analysts also pointed to the upcoming debt curling as contributing to the movement in swap spreads.
“Front-end swap spreads have widened ahead of the “soft” debt ceiling,” said Andrew Hollenhorst, a strategist at Citi. “Treasury needs to bring its cash balance down by mid-March which means less issuance of front-end Treasury securities. Investors buying these securities ahead of the drop in supply are boosting cash prices and widening the spread between the yield on the interest rate swap and the yield on the cash security.”