Canaries at the Treasury over negative swap spreads

The FT's Gillian Tett today highlighted a curious reversal in Treasury bond spreads, asking in her article Will negative swap spreads be our coal mine canaries? whether we might be seeing the start of something scary.

Tett explains that the yield on ten year Treasuries is supposed to be lower than the cost of borrowing in the interbank market, or swaps. The idea that this "swaps spread" is always positive assumes, logically enough, that private banks will go bust before governments do.

But recently there has been an inversion of some swap spreads, so it is now cheaper for banks to lend to each other than to the US and UK governments through 30- and 10-year government bonds. Is this the canary that indicates a deadly gas leak at the Treasury?

Unless the government is hiding something, the risk now being priced in should be that of extra supply rather than default, ie nothing more deadly than supply and demand. This is no surprise: the transfer of huge debts from private to public balance sheets after the bail-outs means Treasury issuance and yields must inevitably go up. Meanwhile, the ghost of the credit freeze is presumably a weight on swap prices, rather than the reverse. Add in temporary market factors and the prices were simply pushed together until they crossed.

The question Tett poses is whether a continuation of this inversion would matter. It would mean losses for a few traders in the short term, and headroom for mischievous pension funds to do a "Rock", ie fund their long-term liabilities in cheaper short-term markets, such as the interbank market. It also raises the unappealing prospect of a carry trade at the Treasury's expense if the margin grew wide enough (the swaps spread on 30-year UK bonds is already negative 40 basis points).

The inversion might also worry economists. First, they would they have to find a new name for Treasury yields as ‘risk-free rate of return’ won't do it any more, and then they'll be honour bound to argue that rational governments should do a "Rock" too.

Unless the next Chancellor is Milo Minderbender, we shouldn't expect to see this. Replacing Treasury issuance with cheap borrowing from banks that the government itself underwrites would be entirely circular, although it would add a nice twist to the too-big-too-fail debate.

Perhaps the main problem with the negative swaps spread is simply that it reminds us of a nasty truth; our public debt is getting more expensive to service.