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 yield 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. While that might be slowing changing given recent events, one headwind to that flow is the anticipated optical widening given the large March futures roll, which is worth around 20bp. The view is that there will be a sharp re-widening in 3-Year swap EFP to reverse the optical narrowing once roll has occurred. To test this, we went back over the past 22 years and examined how 3-Year EFP evolved in the month after a roll worth 10bp or more. There is a wide dispersion of outcomes, with the average subsequent move basically unchanged. So what conclusion can we draw? We would still favour widening, given that the roll will push the spread to 0bp, but whether the full narrowing is reversed is very debateable.”