Archive 2011

Widening FX basis swap masks more critical relationship between Euro and US banking systems

However, a wider Euro basis swap does not necessarily mean a negative Euro, according to ING IM.

Jaco Rouw, Senior Investment Manager, ING Investment Management says: “Over the last several weeks, the Euro basis swap has continued to widen and become more negative. Indeed, just under a week ago on the morning of November 30th, the three-month basis swap traded at -167 basis points. To put this in context, around the time of the Lehman Brothers crisis, there were only five days at which the basis swap traded below -150 basis points.

“It is important to note that the basis swap reflects the price of swapping EUR funding to USD funding, meaning that the difference between EUR deposit rates and USD deposit rates does not play a role. More important is the strength of the Euro banking system relative to the US banking system.”

Over the past few months, much like the duration of the Lehman’s crisis, ING IM has observed that it has become difficult for Eurozone banks to get funding directly from US banks. ING IM believes that one potential way to circumvent this issue is to borrow in Euros, for example, from the ECB, and then use FX forwards to swap the loan into USD.

Jaco Rouw continues: “As worries rise about the stability of the Eurozone banking system, US banks are charging ever higher rates for them to borrow. This is expressed by the Euro cross-currency basis swap moving more negative. The effective cost of USD funds for Eurozone banks then effectively becomes US Libor plus the inverse of the basis swap as there is no real difference between a positive spread on the USD leg and a negative spread on the EUR leg.”

The asset manager notes that, in 2008, this widening of the basis swap coincided with a much stronger USD versus the euro. One reason for this was that at that time, most USD assets were extremely illiquid. Therefore, Eurozone market participants had an incentive to raise EUR funding and use the proceeds to buy USD spot to repay the USD loan. This FX transaction resulted in a stronger dollar versus the euro.

Jaco Rouw continues: “This time around, there is no liquidity problem when it comes to selling USD assets. Therefore, Eurozone market participants that find it difficult to get USD funding can simply sell their USD assets and use these proceeds to repay their USD loan, making the transaction currency-neutral.

”The temporary re-pricing of USD liquidity swap arrangements by 50 basis points and the establishment of temporary bilateral liquidity swap arrangements means that, at present, there is no need to offer liquidity in non-domestic currencies other than the USD.

Moreover, the ECB announced that the initial margin on its 3-month dollar lending operations will be cut to 12% from 20%. In reaction to this, the three-month basis swap narrowed to -117 bps initially, and is currently trading at – 132 bps.

Jaco Rouw concludes: “Although it is positive that there is coordinated central bank action, it does not solve any of the core problems experienced in the sector, such as sovereign debt no longer being risk free and the banks’ balance sheets being under pressure. In light of this, we would fade any strongly positive market reaction.”

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