David Chaston looks at the forces unusually driving swap rates below NZ government bond yields, anomalies defying the credit risks involved

The purpose of this article is to point out an oddity in financial markets.

Many readers will notice swap rates have been falling recently, especially swap rates at the short end of the rate curve.

The falls for the one year looks dramatic where the scale is recent.

But over the longer term, as the chart below shows, it isn't too special. True it is falling, and that gives strong market signals.

Swap rates are a key tool for banks and other financial institutions for their interest rate management. They need to hedge interest rate risk and the swap rate reflects the supply/balance of these forces.

NZ government bond (NZGB) yields in secondary markets reflect what investors will take as a return for the term to maturity of that bond. In addition to normal investor demand and expectations, this market is influenced by bond supply. In times of strong issuance, and much alternative availability, investors can come and go as they please as they know there will be plenty available. Only higher yields from the alternatives keeps demand for a particular maturity.

So the swap and government bond markets are generally influenced by the same forces, but specifically influenced for quite different factors in their separate corners of financial markets.

Generally you would expect the more 'risky' swap markets to be priced higher than the pristine-rated government bond markets.

But this is where recent conditions have turned unusual.

Now, swaps are 'cheaper' than NZGB yields. It is a very recent twist.

The difference shows how fast this twist has happened.

In swaps market, the desire to lock in fixed rates is lighter now due to weak loan demand. That means the upward pressure is low, so the pay side pressures dominate, which put downward pressure on these negotiations and deals.

In contrast, rising government bond issuance to finance larger deficits is keeping yields in this market elevated.

They are separate corners of the financial markets, so it is quite conceivable they move in different ways, even if it's unusual.

The risk element is being overwhelmed by the sudden drop in pressures to hedge loan demand, because loan demand is weak.

We have focused on the one year here, because readers are likely to be following swap rates as an indicator of where mortgage rates might track.

But in fact, the anomaly is more pronounced for the longer maturities.

Theoretically, these anomalies should not exist, as swap rates represent a weaker credit quality than a NZGB, and thus should be arbitraged. But they do exist and may persist for a short time. The smallness of our financial markets probably contributes to less arbitrage capacity and activity.

Regulation plays a part too. Many countries require government bond market makers to hold more capital, reducing appetite to hold large government bond portfolios. US swap spreads also have similar anomalies.

Locally, our yield curve is expected to steepen due to the looming Reserve Bank easing cycle, so shorter NZGB maturities will outperform longer ones.

But the big influence here is that our economy is slowing, and this results in less demand for funding, which in turn exerts less upward pressure on swaps.

*H/T to JW and IS for background briefings for this review.