(Bloomberg) — Traders are piling back into a popular hedge fund strategy that bets on US Treasuries outperforming interest rate swaps.
The so-called swap spread widener trade — which uses derivatives to wager that the gap between rates on interest-rate swaps and yields on Treasuries of the same maturity will grow — came under pressure at the start of the week after a Japanese bond market rout and rising tensions between the US and Europe over Greenland sent bond yields higher.
The moves threatened to derail a widening trend in the spread that had been in place since markets recovered after April’s tariff-induced rout. But as this week’s tensions eased after US President Donald Trump said a framework of an agreement on the Arctic island was reached, the trade was back in play.
By Friday, the 30-year swap spread reached as high as 62 basis points inverted, the widest since December 2022, rising by about 8 basis points this week from a low reached on Tuesday.
The swap spread trade has gained in popularity in recent months in large part due to expectations that Trump’s deregulatory agenda will free up cash on banks’ balance sheet, which in turn will favor Treasuries. Spreads popped wider recently in response to comments by Federal Reserve Governor Stephen Miran who said that “sweeping deregulation” will support further monetary easing.
A December BIS report put the value of the cash component of the swap spread trade at around $631 billion, more than doubling from $281 billion in the first quarter of 2024 and largely driving the growth of hedge fund exposure to Treasuries. That’s trailing the much more popular basis trade strategy, which bets on discrepancies between cash bond yields and futures. Morgan Stanley recently reported the cash-versus-futures basis trade close to $1.5 trillion.
Rate swaps are usually an exchange of fixed for floating rates. The side that receives the fixed makes money when interest rates fall, so the position acts as a way for banks to add so-called duration without owning cash Treasuries on their balance sheets.
Several recent policies are adding fuel to the swap spread widener trade, according to Wall Street strategists who have come out in favor of the strategy. Trading in many of these contracts is anonymous, making it difficult to identify the firms involved and the exact beneficiaries of the bets.
Trump’s efforts to reduce the cost of home ownership, including ordering Fannie Mae and Freddie Mac to buy $200 billion worth of mortgage-backed securities will support “hedging flows via paying in swaps from GSEs,” according to strategists at Barclays PLC. Recent steps by the Federal Reserve to calm conditions in the repo market with purchases of Treasury bills are favoring the long-cash side of the trade.
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Barclays hold a long position in the 5-year sector based on potential for MBS hedging flows while Morgan Stanley are in 2-year swap spread longs citing the current benign conditions in funding markets, an indication that cash remains plentiful. Meanwhile, strategists at TD Securities this week said swap spreads should widen this year, as funding conditions ease, Treasury demand remains robust, and bank deregulation unlocks dealer balance sheet capacity.
The trade does not come without risks. In April, it violently blew-up as firms looked to unwind positions amid margin calls after Trump’s tariff liberation day announcement roiled markets. A similar shock or policy shifts could again threaten to unravel the bets.
A changing outlook for Treasuries supply and the influx of corporate issuance, including a debt binge for artificial intelligence hitting the market as early as next week, could also to take some wind out of the recent swap spread widening by pushing Treasury yields higher.
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