While financial market participants have spent considerable time preparing for the first Federal Reserve rate hike in almost a decade, the divergence in policy compared to ongoing quantitative easing programmes in Europe and Japan, along with the increased regulatory pressure on bank balance sheets has resulted in some unexpected movements in the pricing of FX forward markets. Cross currency basis, or the difference between 3 month interest rates implied by FX forwards and money markets, has widened significantly in the last month and now exceeds 50bps for both Euros and Yen.
The FX forward market is one of the largest and most liquid financial markets, with daily turnover in EURUSD forwards alone estimated at close to USD 1 trillion*. Pricing of FX forwards is normally closely tied to the difference in interbank rates in the two respective currencies, with the deviation from this theoretical price limited as borrowers, such as banks, can choose to switch the currencies in which they fund to obtain the lowest rates and sophisticated investors can choose to enter arbitrage trades to profit from mis-alignments. Typically large distortions occur only in times of financial market stress, where liquidity and counterparty credit concerns reduce the willingness of investors to extract these “arbitrage” profits.
Should the current distortions be read as a warning sign that that we may return to the 2008 era of banking stress? Personally, I think not since other indications of stress in the banking sector such as bank CDS remain at normal levels. While there does not appear to be a single, simple explanation for why the FX forward market has become so distorted, the following factors all seem to have contributed:
Is there a limit to how distorted FX forward pricing can become? Most major central banks have access to US Dollars via swap lines with the Fed, and offer access to these dollars to local banks at a premium of 100bps. However, banks may still choose not to access this dollar funding either out of concern around the stigma attached to the use of the facilities or because of the balance sheet cost associated with providing customers with cross currency funding. It is possible that the cross currency basis could temporarily exceed the backstop provided by central bank swap lines.
Several of the factors I have cited above are quite long term in nature, while others will fade as we move past the Fed rate decision and into 2016. On balance I’d expect the current extreme level of cross currency basis to fall, but investors should be prepared for currency basis to remain volatile over the coming year. The distortions seem set to continue to favour US investors looking to hedge foreign assets back to US Dollars, while the cost of hedging for Japanese or European investors holding US assets may become prohibitive at times.
*BIS Triennial Central Bank Survey 2013