Westpac: Swap Spreads: How Wide Can They Go?

Westpac note that “as is well known, swap spreads in Australia have been widening rapidly across the term structure of late. They are now back to levels last seen in 2012. As for how wide they can go, history can provide context and guidance, at least as a starting point. It is not unusual for spreads to widen at the beginning of tightening cycles, as the market pre-empts the degree to which cash and wholesale market rates will rise. Then, in the past they widened again at the end of the cycle, as restrictive policy encourages mortgage-related hedging. The other observation is that current spreads are now wider than the pre-GFC average levels. That is intriguing because the post-GFC regulatory environment, essentially “de-risked” the market by the introduction of clearing, collateralisation, depositories, etc. If that is true, then it suggests that, everything else being equal, spreads are already very wide to a concept of “fair value”. In our view, however, there are unique liquidity and technical conditions which are keeping spread wide for now. We suspect that we need to be further into the RBA cycle before a narrowing trend will evolve, led by the longer EFP, given the steepness of the box”