Worry about the pending fiscal cliff and its implications for the US sovereign rating are weighing on USD 10-year swap spreads and may be the catalyst that tips them into negative territory.

Swap spreads already tightened to zero following the Federal Reserve’s third round of quantitative easing launched in September before moving back into low single digits.

But it’s the fisal cliff, the pending tax increases and spending cuts that will automatically kick in in 2013 if Congress fails to agree on measures to avert them, that are now spooking investors.

“There are salient concerns over the sovereign credit rating, however I fail to see how an investor would take on the credit of a financial institution (via swaps) over that of the US Treasury (bonds) which negative rates would suggest,” said one swaps trader.

The swap spread is the difference between the swap rate, or the fixed rate of an interest rate swap, and the corresponding Treasury yield. An interest rate swap exchanges a fixed payment for a floating payment and is tied to the London Interbank Offer Rate, or Libor.

In normal conditions, the Treasury yield should be lower than its corresponding swap rate, as government debt is considered to be less risky than bank debt. When Treasury yields are higher than swap rates, swap spreads invert.

The typical catalysts for swap spreads are Treasuries, mortgage-backed securities (MBS) and bond supply. That relationship was demonstrated by the Fed’s QE3, as convexity selling occurred between Treasuries, swap spreads and MBS.

Fixed-rate mortgages are tied to the 10-year Treasury yield. When yields fall, mortgage rates drop in sympathy. However, MBS have negative convexity, which means they cannot rise in price rapidly enough to accommodate the drop in interest rates.

Negative convexity is due to the fact that borrowers have the option to prepay their loan and refinance at a better rate. That increased prepayment risk reduces the price gains and causes the convexity selling.

To smooth out duration, an MBS investor will purchase a longer-dated asset, such as a Treasury or swap rate, facilitating the tightening in swap spreads.

THE NEW NORMAL?

The decline in mortgage rates sparked by QE3 led to heavy selling in swap spreads. That pulled the 10-year spread to zero, although it moved back up by the end of September as MBS repriced.

The 10-year spread has plumbed briefly into negative terrain in 2009 and 2010. Other swap spreads, both USD and in other currencies have also inverted.

In fact, the 30-year swap spread went negative following pronounced selling in 30s in reaction to the Lehman collapse in 2008. The trade was not expected to persist for the long term, but four years later, it remains negative and is considered the “new normal.”

The 10-year swap spread is now expected to track a similar pattern as old worries resurface.

This week, Fitch reiterated its negative outlook on the US AAA rating and urged the government to quickly resolve the fiscal cliff, lift the debt ceiling and put a credible deficit reduction plan into place now that the presidential election is over.

“Failure to reach even a temporary arrangement to prevent the full range of tax increases and spending cuts implied by the fiscal cliff and a repeat of the August 2011 debt ceiling episode would mean that the general election had not resolved the political gridlock in Washington and likely result in a sovereign rating downgrade,” the ratings agency said.

Before the presidential election, the 10-year Treasury yield stood at 1.72% and the 10-year swap rate stood at 1.71%, according to the Federal Reserve website. That saw the 10-year swap spread briefly flirt with negativity.

That in turn suggests the market is pricing in a risk premium to Treasury debt over that of the interbank market.

Supply and demand are other factors affecting swap spreads.

“There has been a reasonably robust issuance calendar, therefore there is demand from hedgers,” the trader said. “I believe that a lot of the movement in spreads is attributable to this element.”

The Bank for International Settlements pegged the size of the interest rate swap market at around $442 trillion in aggregate outstanding in its June 2011 survey.

In the intermediate term, swap spreads will take their direction from the fiscal cliff scenario. If there is no resolution to the event risk, they will move wider as Treasury supply will be reduced.

However, many believe some compromise will be met which will result in some fiscal tightening.