Front-end swap spreads: How much is left in the tank?

Research evidence excerpt

Front-end swap spreads: How much is left in the tank?

Barclays | Interest Rate Derivatives

• We close our 2s7s beta-weighted spread curve steepener and shift to outright 7y spread

wideners. Historically, belly spreads tended to widen after banks earnings season as issuance

related tightening pressures fade.

Front-end spreads: Fading tailwinds

Front-end swap spreads benefited in the first half of the year from a favorable backdrop on the

back of benign funding conditions, Fed bill purchases via RMPs, and increased dealer balance

sheet capacity from SLR relief. 2y spreads were resilient when the US-Iran conflict escalated in

March and as spread vol picked up (Figure 1 and Figure 2), outperforming longer tenor spreads,

which experienced more pronounced tightening. In fact, the front end is the only sector on the

curve where spreads are wider year-to-date, while the rest of the curve is about 3-10bp tighter.

We believe the market is pricing in a worsening fiscal outlook in long-end spreads (see

here).

Looking into the H2 26, the question is how much wider can 2y spreads get and could they

widen into single digit heading towards zero? We do not think so. We think the high-water

mark in funding conditions is behind us. While spreads should continue to benefit from

benign funding conditions, we think there's less impetus for them to widen further from

here. The Fed has pared back RMP purchases and net bills issuance to private investors is

expected to rise in the second half which may create pressures for funding markets.

Our fair value for 2y spreads is in the -15bp area and while there is some room for

overshoot, we believe they are fairly priced.

Trade Recommendation: We close our 2s7s beta weighted spread curve steepeners (flat on