Steve Quayle News Alerts

July 31, 2003
By Eric Burroughs

NEW YORK, (Reuters) - U.S. swap spreads blew sharply wider on Thursday, suffering one of their worst weeks since the 1998 LTCM crisis as the big rise in benchmark yields had mortgage investors hammering the market with heavy hedging.

Five- and 10-year spreads widened dramatically, by more than 8 basis points, in what traders described as a market in which it was increasingly difficult to get trades done and where dealers are struggling with the overwhelming needs of the mortgage universe.

"This can't go on for much longer because the market can't take this. Someone's going to get into trouble," said one head trader at a U.S. bank.

Upbeat data showing unexpectedly strong second-quarter economic growth, better factory output in the Chicago area and still-declining jobless claims drove up 10-year Treasury yields and swap rates by as much as 30 basis points during the day, unleashing the latest round of mortgage activity.

Swap spreads came under repeated fire from mortgage accounts grappling with major extension of the duration in their portfolios that forces them to adjust quickly, either by selling Treasuries or doing the equivalent in swaps, paying fixed rates.

The duration dilemma has been compounded because mortgage security coupons shrank as yields hit 45-year lows, making them even more sensitive to the nearly 1.5 percentage point jump in yields in the past six weeks. The selling drives yields still higher and causes yet more big hedging from the $4.9 trillion mortgage universe.

Everyone from Fannie Mae(nyse: FNM - news - people) and Freddie Mac(nyse: FNM - news - people) to major banks holding mortgage-backed securities is forced to cut down the rapidly expanding duration, traders said.

"Any mortgage holder is getting demolished here," one trader said.

Ten-year spreads shot up an unprecedented 8-1/2 basis points to 58-1/2 basis points over Treasury yields and are now nearly 17 basis points higher for the week. Five-year spreads skyrocketed 58 basis points from 49-3/4 on Wednesday and 40-1/2 last Friday.

"The violence of the move has been astonishing," said Eric Hiller, head of interest rate research at Banc of America Securities. "Ninety-nine percent of it is mortgage related."

Two-year spreads have also been crushed as the stock market's ongoing gains and optimism on the economy have erased all remaining hopes for another Federal Reserve rate cut. Some investors are even thinking about rate hikes. The two-year spread is out to 28 basis points from 20 late last week.

Hiller said the move was not related to credit worries in the banking system, as sometimes can be the case in the swaps market. Last year swap spreads popped wider when unfounded rumors swirled about credit problems at J.P. Morgan Chase.

The selling pressure has been relentless this week and has resulted in spreads suffering their worst widening since the bond market's last mortgage-related plunge in late-2001 and even the crisis days of 1998, when the giant hedge fund Long-Term Capital Management nearly collapsed.

Making matters worse for swaps is the hefty widening of agency spreads on reports the European Central Bank was trimming its holdings of Fannie Mae and Freddie Mac debt. Both agency and swap spreads tend to influence and sometimes reinforce each other.

http://www.forbes.com/personalfinance/retirement/newswire/2003/07/31/rtr1045646.html