Three areas in swaps started to show bizarre never thought possible shape changes in the risk free curve, or rather three areas were the most interesting.
- The 30 year interest rate swap which indicates technical pressure occurring on pension plans and other real money investors;
- The long dated interest rate swaps in long dated forward space;
- The risk premia in forward space for the curve showing how effective the market expects public policy and Fed policy will be and to what the main risk variable is in making successful policy
Long dated 30 year swaps have traded since the market started in the late 80s from as tight as 15 to 20 basis points (.20%) to as wide as 60 to 70 basis points. The instrument was embraced by pensions and long duration money managers as they allowed the ability to quickly change duration exposure given disbursements or losses or gains in the pension surplus/deficit developments. After Lehman failed 30 year interest rate swaps traded to as low as 60 basis points under US Treasuries ( - .60%) showing incredible "short squeeze" in pension funds as any price was paid for duration and given no cash was available given how every other asset class was ravaged. In short it indicated a possible failure in broad swaths of US pension plans. 1930s stuff. Then after Obama provided a masterful week of soothing the panic as he showed he would do stimulus necessary to provide 2 MM new jobs (week straddling end of November and beginning of December) and the market felt we were stepping away from the depression cliff, stock markets rallied up and this long term swap rate moved to a still concerning 12 to 16 basis points over treasuries.
Since the Obama-Biden Plan memo float of Tuesday this rate is headed back down to negative 16 basis points under treasuries showing we are returning to market expectations for disaster.
The long dated (I use 10 years) 10 years forward interest rate swap is an interesting way to "cuff" market expectations for what will be nominal GDP. If one thinks clearly - it is obvious that the short term risk free rate will over time approximate GDP growth plus inflation. The 10X10 went from 4 1/2% to 5% - where it had been for over a decade and plunged to 3%, showing a market expectations for potential GDP, or trend GDP dropping 1 1/2%. Or if trend growth is maintained it requires deflation expectations for the next 20 years. Japanese lost decade indeed or for the size of the USA economy more like 1930s all over again. Again in late November with Obama's solid declarations a fiscal fix was believed in and then forward had risen to 4%, but in the last few trading sessions it is falling again.
The risk premia can be calculated by looking at forward forwards against each each in space far enough forward that immediate business cycle expectations are not a factor - say starting 7 years forward. This risk premia moves from 10 or 12 basis points per annum when the market has most confidence in fiscal probity in policy and an effective Federal Reserve. Occasionally when it is thought the Federal Reserve is flirting with endemic inflation or irresponsible public policy is forthcoming is has gone to as much as 60 basis points per annum. Before the end of November the risk premia had plunged to negative 30 basis points per annum pricing that the fiscal and central bank risk had shifted to endemic deflation. Think of that - the long term risk fee largest bond market there is had implicit expectations for a 10 year deflation. After Obama did his week of grace in November/December, the risk premia has moved to positive 10 basis points. Still low but no longer expected calamity. It has maintained despite the long term interest ate and stock market showing concern over the actual fiscal stimulus in the Obama-Biden Plan.
I find is somewhat grim amusement to find folks talking about inflation and gold and all of the day to day trading stuff while I am seeing WW III risk appearing in the risk free yield curve.
Going forward have to watch these three levels closely. I would prefer to see the long dated interest rate swap show some confidence returning in pension plans, or start to show it isn't as bleak for them as was indicated in November. I hope the risk premia and the forward nominal GDP implicit does not go back into duress. I certainly would not be long any assets, especially equity, if there was any risk of this occurring.