Swap Rates remain at historic heights as an indicator of stresses in financial system

14th January 2009

The financial system remains under extraordinary pressure and mirrors the persistently wide spreads elsewhere in the fixed income and money markets. In money markets spread widening seems here to stay. January 09 saw the 10-year EURO swap spread at almost 50 basis points. Back in the early nineties the long term average 10 year European swap spread was about 29 basis points, peaking in the Autumn of 2000 at 71. Come the mid-decade a narrow 5 basis points was the norm.

Companies and a wide range of financial institutions use swaps to limit or manage their exposure to fluctuations in interest rates, or to make money by securing a marginally lower interest rate than they would otherwise be able to do. It’s an agreement between two counterparties often involving a stream of a fixed payment for a floating payment, linked to an interest rate, routinely LIBOR.

Two-year swaps spreads narrowed to around 72 basis points with the fall of Bear Stearns and they’re remained stuck at these levels for some time, during which reversals in the key financial markets played their part.

The good news is the dollar has rebounded strongly to six-month highs and may now be embarking on a long-term uptrend; and stocks have rallied some 10% off their lows. Oil still tumbles.

Trillions of dollars worth of borrowing, investments and hedging is tied to swaps rates and spreads. For example, several UK mortgage lenders reference their products to two-year UK swaps rates. Wider spreads often means higher mortgage rates. The year-long crisis has already seen global bank losses or write downs approach the $500 billion mark, and some expect that to eventually scale $1 trillion.

The key to swaps spreads narrowing will be how long it takes banks and financial institutions to get through the process of "deleveraging" and rebuilding their shattered balance sheets.

Prices of European banking shares have almost halved since early last year, and will only stage a meaningful recovery when the banks, keen for much more liquidity, are recapitalised more adequately.