Why Two-Year Treasury Swap Spreads Can Turn Negative

Summary

The document explains a proposed interpretation of negative two-year swap spreads. The questioner connects a negative spread to an implied expectation that three-month LIBOR will run below the repo rate, which seems counterintuitive because LIBOR is unsecured while repo is collateralized. The answer agrees that this is the implication under the stated interpretation, then points to balance-sheet capacity as a reason the spread can persist.

The suggested trade would require holding a Treasury until maturity to capture the apparent arbitrage, tying up balance sheet for the holding period. The answer says that bank balance sheets were scarce while Treasury issuance was high, making the trade costly to carry; it also notes that the cost rises with Treasury maturity. This is a brief market explanation rather than a detailed derivation or empirical study. It does not quantify the financing, capital, or other frictions, and the quoted longer-maturity spread is a contemporaneous estimate rather than a general rule.

Key ideas

• A negative two-year swap spread can imply an expected LIBOR-repo differential below zero under the interpretation presented.
• The apparent arbitrage requires holding a Treasury to maturity, consuming balance-sheet capacity.
• Scarce bank balance sheets and increased Treasury supply can make the trade expensive to carry.
• The answer suggests that the balance-sheet cost increases with Treasury maturity.

Tags

# Negative 2y swap spreads


# Negative 2y swap spreads












2y swap spreads have dipped below zero for the first time. Can this stay negative and invert more? If my math is correct, the negative swap spread for the 2y leg suggest that the expected path of 3-month libor - 3-month repo is negative which doesn't make sense because libor is unsecured and repo is collateralized.

## Answer by dm63 (score 3, accepted)

https://quant.stackexchange.com/a/47007

Yes, it does suggest that. However the only way to arbitrage that is to hold the Treasury until maturity. So you need balance sheet to be made available for 2yrs. Right now balance sheet is scarce -bank balance sheets are full and the Treasury is issuing a lot of paper. Hence the market charges a lot to hold that trade. The longer the maturity of the treasury, the more it charges. (10yr spreads are -13 I think).

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