An early conclusion or a slowdown in the Federal Reserve’s ongoing balance sheet reduction is anticipated to impact U.S. swap spreads, according to some large banks. These institutions expect a potential widening of swap spreads, reflective of supply and demand risks associated with Treasuries. Swap spreads, the basis-point difference between the fixed rate of an interest-rate swap tied to SOFR and the Treasury yield of the same maturity, play a crucial role in gauging the cost of financing positions in Treasuries.
The focus on swap spreads has intensified following recent comments from U.S. central bank officials hinting at the possible winding down of the Fed’s quantitative tightening (QT). Concerns about the rapid drawdown of funds in the central bank’s overnight reverse repo facility (RRP) have been raised, indicating a potential scarcity of liquidity.
Banks such as Goldman Sachs and TD Securities suggest that the Fed might initiate a slowdown in QT earlier than initially expected, possibly before summer. Since mid-2022, the Fed has allowed up to $60 billion of Treasuries to mature monthly from its balance sheet, effectively increasing government borrowing needs by $720 billion annually.
If the Fed exits QT early, the Treasury’s financing needs would decline, reducing the issuance of U.S. debt and eliminating a supply-related premium to yields. This could result in a lower cost of funding for Treasuries compared to swaps.
Analysts observe that expectations for an early taper in QT have led to a widening of the swap spread curve since January. However, the short end has experienced more significant widening than the long end. The transition to risk-free SOFR from Libor has removed the credit risk premium embedded in swap rates.
The potential scenarios include a continuation of QT until the fourth quarter, as expected by primary dealer banks in a December poll. In such a case, swap spreads might narrow slightly, or turn more negative. Even with a taper, U.S. long-term swap spreads are expected to tighten due to rising net issuance of Treasury debt amid wider budget deficits.
Despite the Treasury’s announcement of no further increases in auction sizes beyond April, net issuance is projected to rise to $1.6 trillion this year. Analysts emphasize the need for investors buying long maturities to reflect the increased cost of financing the growing debt. The spread on U.S. 30-year swaps over 30-year Treasuries has been in the -68 to -73 bps range since the beginning of the year, reflecting the impact of ongoing economic shifts and potential policy changes.
