Popular Hedge Fund Swaps Trade Is Quickly Getting Crowded Again

(Bloomberg) -- A widening move in dollar swap spreads is starting to accelerate again, as strategists at top US banks pile back into long recommendations.

Morgan Stanley, Barclays and Citibank have all touted the spread widener trade, targeting US government debt to outperform interest rate swaps. Since the start of September, the trade has performed well, rewarding those who have flocked to the popular recommendation. 

This can be seen in the 10-year sector for example, where dollar swap spreads have widened in 19 of the past 26 sessions since the beginning of September. On Wednesday, the tenor peaked at 46 basis points inverted and the widest since the start of April.

The “tide wants to head toward wider spreads,” Blake Gwinn, head of US rates strategy at RBC Capital Markets, wrote in a Wednesday note. “That is especially true given volatility is likely going to remain low with no new government data to really shift the Fed narrative.”

Morgan Stanley has entered into a long two-year swap spread trade, citing too much pessimism around funding conditions into year-end. “We think markets are again overly pessimistic on funding conditions and see lower implied funding as more likely in the coming months,” wrote strategists including Matthew Hornbach. Calmness in the repo market would be a positive factor for front-end spreads. 

Meanwhile, strategists at Citibank reiterated their long front-end swap spreads trade recommendation, seeing little downside risk to the two-year tenor now that repo intermediation has not been challenged. In the long-end of the curve, Barclays is also now recommending wideners, citing an improving fiscal outlook. 

A continued widening move in swap spreads is not a sure thing however. Citi strategists flag foreign reserve manager demand as a potential warning sign of a re-tightening trend. “One risk case is the continued selling, or maturing, of USTs by foreign reserve managers,” strategists including Jason Williams wrote in a note. 

For its long-end widener recommendation, Barclays cites potential spread tightening risks from convexity-related receiving flows in swaps, triggered by a risk-off move from a deteriorating US economic outlook.

October seasonals also show some warning signals. In the 10-year sector, the month has seen an average spread tightening move of 9.5 basis points from 2021 to 2024, according to data compiled by Bloomberg.  

Spread widener positions came under pressure in early April, in the wake of President Donald Trump’s announcement of steep tariffs, causing spreads to collapse and washing out positions for the trade.

--With assistance from Alexandra Harris.

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