Today’s topic will once again involve swap spreads. I am admitting this fact up front in the hopes of convincing you to read on. I know many readers find this obscure part of the institutional fixed income market complicated, and more often than not, boring. I get it. It’s not nearly as exciting as reading about strapping on some S&P 500 risk, or selling VIX, or god-help-you, buying the latest ICO offering. But I firmly believe that negative swap spreads were an anomaly from the 2008 Great Financial Crisis, and monitoring their return to “normal” levels offers some important clues as to the development of the economic recovery. It is an important indicator that many strategists are missing.

I have long been banging on the table that shorting swaps was a better way to position a portfolio for rising long-term yields – A Better Way to Short the Bond Market? I don’t want to repeat the same argument again, but let’s have a quick recap. When the Great Financial Crisis hit, most market participants would have assumed that swap spreads would have exploded higher, much like they did during the Long-Term-Capital-Crisis. In the past, worries about credit risk from the banks that issue swaps meant that investors bid up the price of risk-free US Treasuries, sending the spread soaring higher.

In the initial days of the Great Financial Crisis, US swap spreads did, in fact, start to widen. But then, much to almost everyone’s surprise, swap spreads collapsed below zero. It made no sense. Why would investors ever enter into a swap arrangement with a bank that has credit risk instead of just buying US Treasuries? Especially in those days when no one trusted the financial soundness of banks.

Well, the answer was that it had more to do with financial system’s plumbing than a logical decision by markets. And the next time some newly-graduated-business-school-keener lectures you about Professor Malkiel’s market efficiency theories, just show them the chart of the US 30-year swap spreads and ask them to explain it.