First, some background on swaps: Let’s say you’re borrowing at an adjustable interest rate that fluctuates along with the LIBOR (London Inter-Bank Offered Rate). Let’s also say you’re not so comfortable with the LIBOR’s fluctuations. You can engage in a swap and get someone else to pay that fluctuating interest rate for you, while you pay them a constant interest rate. The constant rate you pay is the swap rate. Now the swap rate stays constant during the lifetime of each individual contract, but the swap rate you can expect to pay for a new contract changes all the time; in fact, many swap rate series in FRED are updated daily at various times.
So what’s interesting about all this? The graph shows the 12-month swap rate, which combines the old (red line) and new (blue line) sources of the data,* and the LIBOR. Note that the swap rate and the LIBOR are different. This difference has to do with expectations of the future evolution of the LIBOR, risks attached to the LIBOR and the swap contract, and the implicit insurance that you get from a swap. Notice that the difference increased pretty significantly at the time of the financial crisis; it has narrowed recently but is still noticeable. If interest rates have stayed quite low, what’s behind these changes?
There are at least three possible factors: First, a swap carries the additional risk that your counterparty may default, in which case you’ll be on the hook for paying the interest. That risk of default may have increased—or at least the perceived risk may have increased. Second, there have been doubts in recent years that the LIBOR may not accurately or transparently reflect market rates. Third, expectations about the evolution of the LIBOR during the length of the swap contract may have trended away from the current value more than they had in the past.
*NOTE: FRED had included swap rate data from the Board of Governors of the Federal Reserve System until the series were discontinued in 2016. FRED has since replaced—swapped?—those important financial data for data now supplied by IBA (Intercontinental Exchange Benchmark Administration).
How this graph was created: NOTE: Data series used in this graph have been removed from the FRED database, so the instructions for creating the graph are no longer valid. The graph was also changed to a static image.
Suggested by Christian Zimmermann.