EUR/USD And Cross-Currency Basis Swap

Includes: FXE, UUP
by: Evariste Lefeuvre


For the third time in less than five years euro cross-currency basis swaps spreads are falling concurrently with the EUR/USD.

Yet, cross-currency basis swaps spreads are mostly driven by bank credit risk and dollar shortages, that is the “convenience” of holding dollars.

Interestingly enough, this time, too much Euros available may be the reason behind the recent sharp decline in the basis.

For the third time in less than five years euro cross-currency basis swaps spreads are falling concurrently with the EUR/USD. For the third time it is worth stressing that the synchronicity of those moves is not linked to any theoretical or empirical relationship between both series but to the presence of a set of common drivers: credit risk or dollar scarcity.

Cross currency basis swaps are quoted as USD Libor versus the Euribor plus/minus a spread. According the BIS, "a basis swap spread of x basis points indicates that a counterparty wanting to swap U.S. dollars for a foreign currency loan must pay x basis points above/below the benchmark floating rate on foreign currency funds in return for US dollar Libor". On the contrary, a non-US borrower will swap EUR for U.S. dollars paying U.S. Libor and receiving x basis points above/below Euribor. Today, x is deeply negative again for EUR/USD cross currency swaps, which means that a large portion of the interest rate received on the Euribor leg has to be given up to get access to USD funds.

The cross currency basis can be explained as a deviation of market yields from their level implied by the covered interest rate parity. The basis widens when the US-implied yield derived from the relative value of EUR/USD spot and forward differs significantly from the current US yield. More explicitly, the basis of an FX cross currency swap can be formalized as:

EUR/USD_forward=EUR/USD_Spot x(1+i_us)/(1+i_eur+basis)

The basis has to be "added"/"subtracted" to the EUR interest rate for this non-arbitrage relationship to be verified.

Hence, if we summarize, we can state that the basis of a cross currency swap is

1. Well proxied by the "addendum" to the foreign Libor (Euribor here) that is necessary for the covered interest rate parity (equation above) to be verified;

2. The portion of Euribor interest rate payment that has to be given up/added to access U.S. dollar funding.

From the equation above, the exchange rate and the basis do seem much more co-determined than driven by any causality. The widening of the basis observed recently has to be found somewhere else than in the directionality of the spot value of the EUR/USD.

The case of the AUD/USD is a very good example of the lack of relationship between FX and basis swap spreads. In spite of the sharp fall of the value of the pair, the BS spread has remained almost unchanged since 2013.

Another example visible below shows that there was no link between the yen basis and the total return of a carry trade strategy long USD/short yen between 2003 and 2007. Any euro-funded carry trade assumption is ill-founded.

I have explained in several posts that the drivers of basis swap spreads were credit risk and dollar shortage: the spread reflects the relative credit risk/credit term structure between financial institutions in both countries (there is an exchange of principal in a cross currency swap), as well as the dollar-funding abilities.

a. If, for instance, European banks have a higher credit risk than their U.S. counterparts, the spread will be negative: one leg of the swap will receive USD Libor but will pay EUR Euribor minus a spread which epitomizes the credit premium.

b. In the same vein, a surge in USD needs might force them to borrow more in EUR and then swap the proceed in USD. The rise in demand for swapping might lead to a widening in the basis especially when arbitrageurs are concerned with the solvency of banks.

My Basis swap model is based on those factors: the spread of "bor/OIS" spreads and the ratio of Financial CDS spreads are used as proxy of credit risk. The VIX and the trend in EM currencies are used to highlight the dollar shortage. Lastly, I use central banks' relative balance sheets as indicator of liquidity provision. The model clearly fails to explain the current widening of the cross currency basis.

Both episodes of widening European basis swaps spreads in recent history were linked to a combination of currency mismatch in European banks' balance sheet and uncertainty on their solvency.

The first dislocation of the market took place in the midst of the 2008 crisis. It might sound as a paradox that U.S. banks fared better than European banks at the inception of the crisis, but there is a clear link and good timing between the relative under-performance of European banks sub-index and the widening or the EUR basis swap spread. Interestingly enough, it was mostly the inability of European banks to raise USD funds through the traditional channels of central banks' deposits, FX swaps and interbank markets that led to the sharp widening of the basis.

The 2011 episode was also related to banks through the dollar funding crisis and, in particular the huge withdrawal of funds of U.S. money market funds away from the eurozone. It hurt badly many European banks during that period. The reason why there was a concurrent fall in bank stocks and increase in the basis spread was that many European banks were still relying on short term USD borrowing to fund long term portfolios of assets (commodity, infrastructures…).

In both cases, the crisis was altered by the provision of dollars and liquidity by central banks. On top of that, the creation of (the foundations of) a banking union and the promise to do whatever it takes to save the euro by Mario Draghi clearly reduced the risk aversion towards European Banks. As can be seen above, the relative performance of European and U.S. banks has remained flat since 2012.

Today's strains on European banks have eased significantly: Banking Union, Single Supervisory Mechanism (SSM), asset quality review (AQR) and stress tests, VLTRO…. It appears unlikely then that the increase in the relative cost of USD financing be linked to any sharp rise in the solvency risk of European banks. The usual suspect for wider cross-currency basis swaps has to be found elsewhere.

Anecdotal evidences might explain a small portion of the widening of the EUR basis swap spread: Many multi-national companies have increased their issuances in EUR. The forthcoming implementation of the Bank Recovery and Resolution Directive (BRRD) in Europe could increase the perceived risk of European financial institutions ("bail-in"). The liquidity constraint imposed to U.S. money market funds may also lead them to shy away from non-Treasuries assets (T bills). Coupled with a forthcoming drying up of liquidity in the U.S. (albeit the Fed does not seem as impatient as the drop of "patient" would suggest), it could justify a decline of the basis. But there might be more to that.

If dollar shortages have often (always?) been the key for explaining falls in the basis, could it be, this time, that an oversupply of euros drives the basis sharply downward? Of course, we should always look for signs of credit uncertainties. The ECB gave us its target for balance sheet expansion (roughly on trillion EUR). If investors are bringing this figure forward, as I do in my model below, there is no genuine mispricing.

Bottom Line: Even though the nature of the shortage may change through time, variation of the cross currency basis spread is almost always linked to the scarcity of dollar funding and the associated credit risk of financial institutions. It might be linked to institutional uncertainties, banking risk, but the widening of the basis can always be compared to the "convenience" of holding dollars. Interestingly enough, this time, too many euros available may be the reason behind the recent sharp decline in the basis.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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