Dear All,
I am learning to follow markets for an IRD Trading career in the future. Basically I got a solid understanding in Monetary Policy, Bonds Auctions, Correlation across assets, Risk Sentiments, etc.
However, the most critical indicator, the Swap Spread(the spread between IRS and US Treasury, two curves cross around 5Y), I monitor the spread widen or tighten daily, but I don't know how to understand it. Question1: what does swap spread suggest, how to utilize it while trading IRS or US Treasury?
Question2: Can anyone also kindly share some summary on some methods to be proactive on the curve movements? What I know is front-end is sensitive to the expectation on monetary policy, while the long-end is driven by the market sentiment plus inflation expectation. My knowledge is so limited... Can any of you share more? Thank you so much!
Really appreciate if any of you could provide a guide, thank you so much!
Best regards, BChen
Speaking for myself, it's kinda hard to to it like this... Maybe if you have more specific questions that you wanted to ask?
Sure. Be specific. We know this morning UST rallied a little bit after ADP and will be waiting for NFP. Meanwhile, this morning, treasury curve is outperforming swap curve (Swap spread widens short-end and tightens long-end). I can only describe these moves. But, currently, what useful information will you extract from these? (either for trading IRS or for managing UST portfolio)
Short-term moves, especially nowadays, especially in August, contain very little useful information.
In general, there are a few traditional drivers of swapspreads. There is a paper that I recommend you skim for some basic understanding. The caveat with it is that it's relatively old and out of date, which means that it can only serve as a starting point and some things have changed a lot. However, it can explain some of the basics of swapspreads. http://documents.worldbank.org/curated/en/603931468317080717/pdf/334270…
As to your second question, have you read Antti Ilmanen's "Understanding the Yield Curve" papers, especially part 7? That is a good starting point...
Thank you
in the US... the front end of the swap spread curve (0-2yr) is useful for evaluating overall bank credit & lending risk. During a banking crisis, this swap spread will blow out as the risk of bank defaults increase, banks become less willing to lend, etc...
the long end of the swap spread curve (30yr) is a useful indication for real-money ("RM") demand for interest rate exposure. Think insurance companies, pension funds, etc... These market participants receive "fixed" on 30yr swaps (essentially buying 30yr bonds) but they don't have to tie up regulatory capital to do it. There is less of a credit risk component for 30yr swaps than there is for a 2yr swap....in a banking crisis (for example, Lehman) it takes time to match off all the counterparty swaps...but eventually it all gets sorted out.
This is counterintuitive...one would initially assume that, all else being equal, longer term swap spreads ought to carry more risk..more time = more opportunities for a bank to blow up and create higher relative credit risk. However, the world assumes that the US will never really blow up, and so 30yr swaps become the RM community favorite long duration instrument.
Just a note...1mm 30yr bonds require 60k of regulatory capital to be set aside (sortof like margin in your futures account)...but 1mm 2yr notes only require 15k (makes sense...2yr notes denote less risk from lower DV01). However, this makes the long end more expensive to hold positions in terms of capital efficiency..
BChen, attached some literature from CME group that you may find helpful:
https://www.cmegroup.com/education/files/cme-group-webcast-ir-mbaker-20… https://www.cmegroup.com/education/files/treasury-options-for-fixed-inc…
Also, check out the website curvetrades (link below). http://www.curvetrades.com/index.php/information-center/f-a-q
Good Luck
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