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Traditionally US swap spreads were traded as LIBOR or OIS swaps versus USTs.

In the former case the spread at the short end of the curve was very much a function of LIBOR repo spreads. Further, LIBOR which was a measure of bank credit was fundamentally different from the credit of the US government. Therefore, some value of these short terms spreads could also be ascribed to this difference in credit.

In todays world, most swaps are cleared and therefore the idea of these swaps defaulting is fairly close to 0. Further, with LIBOR now being redundant, we have SoFR swaps versus cash as the benchmark spread. Therefore, barring specials the index on the swap is a fair proxy for funding on the bond at GC.

If we assume SoFR is representative of GC rates, arguably at the short end of the curve, Matched maturity ASW should be close to 0? In fact the only thing which could be driving this away from 0 would be the balance sheet capacity of banks..which implies longer spreads should be negative (if measured as swap over bond yield).

Therefore, in an ideal world where bank balance sheets were not impacted by regulatory bounds and were hypothetically abundant, the new swap spreads should be close to 0. The fact that long end spreads are materially negative shows or implies this b/s scarcity ?

Are their any other subtle factors outside of balance sheet which determine these spreads today (ofc treasury issuance is just a corollary to this point, in that high levels of UST issuance would cheapen certain sectors as balance sheet is constrained).

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The basic point you are making is correct. The main reason why swap spreads are negative is the large amount of Treasury issuance versus the limited capacity to own them. The scarcity of bank balance sheet, caused by increased bank capital regulation, is an important reason. There are also a few others. Consider also that foreign central banks (notably China) have been net sellers of USTs in recent years. On the list also I would put a preference for swaps as an instrument for owning fixed income, due to its off balance sheet nature. Thus, swaps can appear to be free leverage to some institutions, including money managers and pension funds.

Sometimes one reads that negative swapnspreads constitute arbitrage. If you hold the bond versus swap combination, you would collect the swap spread over time. True, but you have to hold the trade for a long time during which you have significant market risk. Plus there are margins to maintain in the repo markets and the cleared swap market.

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  • $\begingroup$ Yes I'd agree that swaps/futures give cheap and easy leverage. If I want to be long, I'd just receive 30y swaps and don't want to have the headache of repo my 30y USTs. Regarding the costs of spreads, I have seen that they are extremely expensive (in a cash/margin sense) to trade. $\endgroup$
    – user68819
    Dec 2, 2023 at 13:50

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