Press Release

New York Fed Releases Reports about Negative Interest Rate Swap Spreads, Trends in Credit Basis Spreads, and the Fed's Pre-Crisis Monetary Policy Framework

October 01, 2018

NEW YORK—The Federal Reserve Bank of New York today released three new articles that will be published in a forthcoming issue of the Economic Policy Review, its policy-oriented journal focused on macroeconomic, banking and financial market topics. The articles are titled “Negative Swap Spreads,” “Trends in Credit Basis Spreads” and “The Pre-Crisis Monetary Policy Implementation Framework.” They focus on the distinct topics of the factors driving the decline of U.S. interest rate swap spreads, explanations for the prolonged widening in credit market basis trades in late 2015 and early 2016, and the Federal Reserve’s operating framework for monetary policy prior to the expansion of the Fed’s balance sheet during the financial crisis.

Negative Swap Spreads: This article looks into factors driving why U.S. interest rate swap spreads have become negative for many maturities over the past two years. This movement of swap spreads into negative territory has been attributed anecdotally to idiosyncratic factors such as changes in foreign reserve balances and liability duration management by corporations. However, the authors assert that regulatory changes affected the willingness of supervised institutions to absorb shocks. The authors argue that when exogenous factors narrowed spreads, the leverage requirements reduced incentives for market participants to enter into trades that would have counteracted the effects of exogenous shocks. The analysis suggests that, given balance sheet costs, spreads must reach more negative levels to generate an adequate return on equity for dealers—suggesting there may be a “new normal” level at which dealers are incentivized to trade.

Trends in Credit Basis Spreads: This article looks into the large, prolonged dislocations in credit market basis trades during the second half of 2015 and the first quarter of 2016. The authors examine three explanations proposed by market participants: increased idiosyncratic risks, strategic positioning by asset managers, and regulatory changes. They find some evidence of increased idiosyncratic risk during the relevant period but limited evidence of asset managers changing their positioning in derivative products. Although the authors cannot quantify the contribution of these two channels to the overall level of spreads, the relative changes in idiosyncratic risk levels and in asset manager derivative positions appear small compared with the observed spreads. They present the mechanics of the credit default swap (CDS)-bond arbitrage trade, tracing its impact on a stylized dealer balance sheet and the return on equity (ROE) calculation. They find that, given current levels of regulatory leverage, the CDS-bond basis needs to be significantly more negative than pre-crisis levels to achieve the same ROE target.

The Pre-Crisis Monetary Policy Implementation Framework: This article describes the Fed’s operating framework for monetary policy prior to the expansion of its balance sheet during the 2007-2009 financial crisis. During this pre-crisis period, aggregate reserves were scarce; as a result, small changes in reserves would affect fed funds rates. The authors assess the pre-crisis framework and find that it met the Fed’s monetary policy objectives by keeping rates close to target but had certain negative effects on financial market functioning and employed operating procedures that were rather opaque and inefficient. During the crisis, the Fed boosted reserves in a bid to foster economic recovery, and this increase necessitated changes in how the Fed conducts monetary policy. The authors find that the Fed’s new approach has controlled rates well since the crisis, suggesting that alternate frameworks can be effective.


The first and second articles are both authored by Nina Boyarchenko, Pooja Gupta, Nick Steele and Jacqueline Yen. Boyarchenko is a senior economist in the New York Fed’s Capital Markets Function; Gupta is a senior associate for policy and markets analysis in the New York Fed’s Markets Group; Steele is a Deputy Director in the Office of Debt Management at the U.S. Treasury Department and a former associate for policy and markets analysis in the New York Fed’s Markets Group; and Yen is a senior associate for quantitative and policy analysis in the New York Fed’s Markets Group.

The third article is authored by Alexander Kroeger, John McGowan and Asani Sarkar. Kroeger is a former senior research analyst in the New York Fed’s Research and Statistics Group; McGowan is an assistant vice president in the New York Fed’s Markets Group; and Sarkar is an assistant vice president in the New York Fed’s Research and Statistics Group.

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