EUR swap spreads: Diverging trajectories

The cheapening of German government bonds relative to Euribor swaps continued in 2020.

If one can point to the structurally higher government borrowing needs in 2020 as a driver, the same cannot be said for 2019, when the move in swap spreads was even sharper. This narrative remains nonetheless valid; we see the cheapening of government bonds relative to swaps in recent years as marking the end of an era, that of ever wider German fiscal surpluses.

The same holds true for 2021, although we think the ‘supply-driven’ swap spreads' re-pricing has now fully played out. Instead, we anticipate the 2021 regime will be dominated by changes in risk premia (typically richening bonds against swaps in times of stress and vice versa). We take an uncharacteristically upbeat view of the risk environment in 2021, and thus see no reason to expect an unwind of the recent richening.

Money market conditions conspire to a roughly unchanged state of play. With the extension of easy TLTRO (Targeted Longer-Term Refinancing Operations) terms that we’re anticipating in December - effectively cheaper liquidity to banks - the contribution from the Euribor-€STR spread should be minimal. On the other hand, some degree of richening could come from less government reliance on money market instruments, and so from lower repo rates.

The first quarter of 2021 should see a further unwinding of the supply-related richening of long-dated swap spreads seen in the last quarter of 2020. In addition, governments ‘terming out’ their borrowing (relying less on T-bills and more on longer-dated bonds) should contribute to a stabilisation of the cheapening of short-dated swap spreads. This should result in a flattening of the swap spreads' term structure (cheaper long-end and richer front-end).