RBC: Still Too Early For Swap Spreads To Tighten

RBC maintain their view that “it’s too soon to fade the widening in swap EFPs, especially at the front end. QE may have ended, taking away one source of swap spread widening pressure, but we think fixed-rate mortgage flows are still large enough to keep pay-side pressure on. The last (October) update from the ABS suggested that fixed flows were around A$23bn in total for the month, with a six-month average of A$25bn. More recent quarterly updates from the banks suggest that the proportion of fixed vs variable flow remains high, and transaction volumes have picked up further, suggesting that balance sheets still need to pay substantial volumes of short-dated swap as a hedge. ANZ noted in its Q122 pillar 3 disclosures that fixed rate mortgages still accounted for about 40% of its flow in January. This was down from about 50% in October (or 43% across all measured ADIs according to the ABS), but it’s still far higher than the ~12% long-term average.”

• “The upcoming March futures roll is another short-term variable to factor in on top of hedging flows. A steep front-end curve and a compositional lengthening in the underlying 3-Year bond basket (Apr-26s enter) will both contribute to yet another large optical roll. Early 3-Year roll activity has been taking place at between 18bp and 21bp, which takes 3-Year EFP back to around flat. While we’ve long been sceptical of focusing too heavily on optical roll effects, the return to a near-zero swap spread might once again prompt some pay-side flow. We note that more theoretically consistent measures of swap-bond show that matched maturity swap spreads are much wider.”
• “We note that a sharp move wider in Bund swap spreads has also added to upward pressure in AUD swap spreads lately.”
• “Despite our view that swap spreads can widen further over the next few months, especially toward the front-end, we still expect swap spreads to end the year tighter. By then, fixed rate mortgage flow should have slowed to more historically normal levels. Fixed rate pricing has already become much less attractive for borrowers, with most lenders returning to the historical norm of offering fixed rates above their variable rates. For much of 2020 and 2021, fixed rates were quite substantially below variable rates. We also expect the general level of new mortgage activity to slow as a softer outlook for the housing market dampens the willingness of sellers to list properties for sale. Hence, while we remain better payers of swap spreads and/or receivers of the 3-10s box for now, we are looking for a turn at some point slightly later this year when the fixed mortgage story begins to fade.”