BIS Warns The Fed Rate Hike May Unleash The Biggest Dollar Margin Call In History

Over the past several months, one of the biggest conundrums stumping the financial community has been the record negative swap spread which we profiled first in September,  and which as Goldman most recently concluded, "has been driven by funding and balance sheet strains, especially since August."

Today, in its latest quarterly report, the Bank of International Settlement focused precisely on this latest market dislocation.  According to the central banks' central bank, "recent quarters have witnessed unusual price relationships in fixed income markets. US dollar swap spreads (ie the difference between the rate on the fixed leg of a swap and the corresponding Treasury yield) have turned negative, moving in the opposite direction from euro swap spreads (Graph A, left-hand panel)."

Given that counterparties in derivatives markets, typically banks, are less creditworthy than the government, swap rates are normally higher than Treasury yields because of the additional risk premium. Hence, the negative spreads point to a possible dislocation. One set of factors relates to supply and demand conditions in interest rate swap and Treasury bond markets. In the swap markets, forces that can compress swap rates include credit enhancements in swaps, hedging demand from corporate bond issuers, and investors seeking to lock in longer durations (eg insurers and pension funds) by securing fixed rates via swaps.

In cash markets, in turn, upward pressures on yields stemmed from the recent sales of US Treasury securities by EME reserve managers. The market impact of these Treasury bond sales may have been amplified by a second set of factors that curb arbitrage and impede smooth market functioning. First, the capacity of dealers’ balance sheets to absorb rising inventory may have been overwhelmed by the amount of US Treasury bonds reaching the secondary market in the third quarter (Graph A, centre panel), causing dealers to bid market yields above the corresponding swap rates. Second, balance sheet constraints may have made it more costly for intermediaries to engage in the speculative arbitrage needed to restore a positive swap spread. Such arbitrage is sensitive to balance sheet costs because it requires leverage, with a long Treasury position funded in the repo market.

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