Westpac: How Much Wider Can Swap Spreads Move?

Westpac note that “swap spreads have been widening across the term structure in recent weeks. That has occurred despite outright yields moving higher. Indeed, the move off all-time lows has shifted the relationship between outright and swap spreads. They have gone from being inversely related to positively so. We suspect that is due largely to fact that cash rates can only go higher, and fixed rate pay-side has accelerated to get ahead of the higher market rates. So how wide can they go? Given where we are in the policy cycle, we should expect them to be slightly wider than their average historical levels. That puts 3-Year EFPs around 20bp and 10-Year EFPs around 25-30bp. There are few receive-side flows at the short end, despite historically attractive carry. Other contributors to the wider spreads are the anticipated optical widening given the large March futures roll, which is worth 15-17bps, ongoing mortgage fixed rate paying and the potential for higher fixings once the RBA hike cycle is underway. At the 10-Year maturity, we think there could be support on a cross market basis, however we will await a more attractive entry level for spread narrowers, especially as the 3-/10-Year box has narrowed quickly.”