Swap Spreads Normalizing As Fed Begins Rate Normalization (Potential Bad News For US Treasury … And Taxpayers)

by Anthony B Sanders
Last night I attended a speech by Heritage Foundation Distinguished Visiting Fellow and Trump adviser Stephen Moore. He is a very optimistic and dynamic speaker and challenged the audience to find one thing that is not going in a positive direction. The person sitting next to me whispered “Don’t say it!”
I was going to raise my hand and ask “What about the $20+ trillion in Federal debt coupled with Federal Reserve rate “normalization”? And the out of control spending out of Washington DC?”
Here is the problem.  US Public Debt has over doubled in size since mid-2008 during the financial crisis as The Fed lowered its target rate and began its quantitative easing (Treasury and Agency MBS purchases) was announced was announced on November 25, 2008. Now around $20.5 trillion of public debt is outstanding and the 2 year Treasury yield is rising (making it more expensive for Treasury to refinance its massive debt load).

As The Fed continues interest rate “normalization” after 10 years of low rates, Treasury is going to feel the pinch of rising rates. The problem is magnified with further deficit spending by Congress requiring the issuance of MORE Treasury debt.

The hope is the the economy will grow faster than it has since The Great Recession.
The good news? We are finally seeing signs of interest rate normalization in 30 year swap spreads. Swap spreads are the difference between the swap rate (a fixed interest rate) and a corresponding Treasury securities of the same maturity.  Swap spreads went into negative territory during the financial crisis and The Fed’s intervention. But with The Fed raising their target rate, we have seen the 30Y swap spread normalizing during 2017 and so far in 2018.

The 30Y swap spread tends to rise during financial turbulence such as the Long-term Capital fiasco and Russian Credit Crisis from 1998-2000. And later during the financial crisis (portrayed in the books/movies Margin Call and The Big Short). BUT since The Fed’s virtual takeover of the financial system (along with other Central Banks), the swap spread went negative and seems to finally be normalizing.

Of course, the biggest problem is Congress and their insatiable spending (coupled with The Fed’s enabling actions).
As Clint Eastwood once said, “Too much sugar is bad for you.” As is too much Federal spending and debt, particularly as interest rates begin to rise.