usdjpy and 30y swap spreads

Stone Street AdvisorsA Quick Look: USDJPY & 30Y Swap SpreadsChiBondKing – [email protected]

BackgroundDuring the financial crisis of 2008, the 30Y swap spread reached unprecedented lows, with intraday prints near -70 basis points. At the same time, the USDJPY breached the 90.00 level and began racing towards 85. Many market participants attributed the negative 10 and 30Y yields to people purchasing swaps (payers) and selling Treasuries. It's worth noting at this time (refer to Drawing 2) that yield movements suggested the opposite. Subsequently, after the deepest point in the crisis (Lehman, Merrill weekend) yields continued to plummet before recovering. The 30Y swap trade looks to have unwound a full month ahead of a recovery in Treasuries as people sold swap contracts and sought the safety of the Treasury market.

Another reason that was offered was an unique phenomenon out of Japan: PRDN hedging. Market participants began to rationalize that the relative strength of the Yen vs. the dollar made paying the 30Y swap in USD but receiving the cashflows denominated in Yen. That, combined with general market sentiment at the time drove the 30Y swap rate to mathematically impossible lows. As a side note: I was decreeing it mathematically impossible when we first broke the zero boundary, but now we all know that what seems impossible has now become the new normal.

See Important Disclosures on page 4

Drawing 1: US Swap Spreads - Sept 2007-Present

Drawing 2: US Treasury Yields - Sept 2007 – Present. Shaded Area: Lehman/MER Crisis

Is The USDJPY Still Affecting 30Y Swap SpreadsWith 30Y swap spreads still at negative levels, it is worth asking if the recent market volatility and strengthening of the USD has had a discernible effect on steepening 30Y swap spreads towards the 0 level. USDJPY is currently at the same levels that we saw during the crisis in 2008. Recent gains in the USD against major currencies has not played out quite well when it comes to the Yen; we started out in 2010 at 92.5 and currently USDJPY is at 87.8. On the same note, the 30Y

swap spread started the year at -14 and is currently at -27: the low for the year was -30, reached on May 7. At first glance, the weakness in USD relative to Yen looks to be a leading cause of the 30Y swap spread, but market observations point to the fact that the hedging phenomenon witnessed in 2008 is no longer prevalent. Looking at the 30D rolling correlation, we are approaching an interesting peak level near 60. During the crisis, the swap spread/USDJPY correlation reached significant levels. As shown in the chart, that has been followed by periods of correlation which suggests that perhaps the Yen hedging theory may actually hold some water, but has taken a back seat to solvency issues, not amongst banks but with soveriegn bonds.

A quick primer on Swap Spreads for those who are not familiar with them: typically wider swap spreads indicate increased levels of risk vs. the perceived safety of government bonds. If you were to look at the 2Y swap spread during the crisis (refer to Drawing 1), a short term flight to quality in

Treasuries combined with selling/unwinding of swaps led to that spread reaching historical highs near 170bps. What that means in a nutshell is that cashflows based on swaps between counterparties implied a very high risk premium as investors sought to move cash into “riskfree” assets. At the same time, however, on the opposite end of the swap curve, rates went negative which if one sticks with the explanation given above, would imply that within 30 years, I expect counterparties (Banks, etc.) to be less “risky” than the underlying government bonds. The same can be said about 7-10Y swap spreads as they are either near or have crossed below 0.

With the recent discussion of sovereign default, one would expect the 30Y swap spread to re-test the crisis lows, given the long term outlook for government bonds, particularly those with long term fiscal/debt issues. Part of this does hold true that while the remainder of swap spreads recovered from “distressed” levels (prime example: 2Y), the 30Y is still negative. One could imply that the residual worries about government bond risk still remains, but I believe that now that market participants have a clearer picture of the trading landscape, the recent deterioration in 30Y swap spreads could be caused by traders looking to the USD's weakness vs. the Yen as a trading opportunity to once again, receive cashflows denominated in the stronger currency.


Drawing 3: USDJPY vs. US 30Y Swap Spread

To quickly test this assumption, I put together a simple linear model that takes the form:

l1 = lm(SS1 ~ JPY)Where: SS1 = 30Y Swap Spread, JPY = USDJPY

The results of this simple linear model tells me some interesting facts. Although the sample size of data (344 days) is not as large as I would have preferred, it suffices for this particular exercise:

Estimate Std. Error T-value P-Value

USDJPY -0.20155 0.00557 -36.16000 2.00E-016

Table 1: Coefficient Summary for l1 linear model

Summary Statistics:

Residual Errors: 9.603 on 344 data points

R2: 0.7917

This simple model accounts for around 79% of the movement within the 30Y Swap Spread (theoretically). However, there are some things worth noting that evidence of autocorrelation for 30Y Swap Spreads (lags 1-4 and 6). USDJPY saw slight autocorrelation at lag 1 however the remainder lags did not show any evidence of this. It's worth noting the volatility of the residual timeseries post-crisis (Mar-July 2009) and the actual Swap timeseries shown in Drawing 3.


Drawing 4: 30D Rolling Correlation (PRICE SERIES) Drawing 5: l1 Model Residuals - linear model

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usdjpy and 30y swap spreads

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