The cross-currency basis blowout and what it means for the USD
- The BoJ seems content to let market forces drive the value of the yen
- Germany is now the lowest yielding market, a title it has inherited from Japan
- We are now seeing a breakdown in covered interest parity
By Max McKegg
USDJPY hardly got a mention in the Bank of Japan’s recent review of monetary policy, nor in follow up speeches by Governor Haruhiko Kuroda. It seems the central bank is content to let market forces set the level of the exchange rate.
One of those forces is the cross-currency swap where a blowout in the basis is forcing up hedging costs, compelling Japanese banks and institutions to consider winding back overseas lending and buying US treasuries unhedged, thereby providing ongoing support for USDJPY.
Investors with access to US dollars to lend in the FX swap market hold the upper hand.
Let’s have a look at the cross-currency basis, see why a once impregnable law in international finance no longer holds, and who wins and loses as a result. We’ll concentrate on the USDJPY basis because that has seen the biggest move. However, the same situation applies to USDEUR.
First, consider the following chart showing the yield on 10-year government bonds in the major markets: the US, Japan, Germany and the UK. US Treasuries continue to hold in a narrow trading range around 1.6%, a significant premium over the others. Germany has inherited from Japan the dubious accolade as the lowest yielding market. Outside of the big boys, Finland has also joined the sub-zero club at 10 years, while Switzerland still tops the rankings with confederation bonds returning -0.60%.
Given the big yield advantage held by the US, offshore investing interest is strong.
Global yields compared
Source: Bloomberg. Create your own charts with SaxoTrader; click here to learn more
Risk averse institutional investors from Japan, Europe and elsewhere – including sovereign wealth funds – want to buy into the US bond market with currency risk eliminated (hedged) still end up with a yield higher than they can get in their home market. Normally that would be no problem. Even with regulatory changes affecting US money market funds driving 3 month dollar Libor up to 85 basis points, investors from zero-bound home markets should be able to hedge through the FX swap market with the forward points matching that 85 basis point rate differential. After hedging costs then, a 10-year US treasury would yield around 80 basis points.
But these aren’t normal times and we are now seeing a breakdown in the closest thing to a physical law in international finance: covered interest parity. The law says that the interest rate differential between two currencies in the money market should equal the differential between the forward and spot FX rates. If not, arbitrageurs will quickly step in to close the gap, making risk free profits along the way. They used to do just that but, post GFC, restraints on balance sheet exposures have largely taken banks – the big players – out of the game.
Now its open slather in the FX swap market, and it’s equivalent the cross currency swap, throwing up all sorts of anomalies and opportunities for real money and hedge fund investors alike. Demand from offshore investors for US treasury bonds has been running strong but so has their need for currency hedges, and with few arbitrageurs on the other side to even things up, the cost of hedging has blown out. This shows up in the USDJPY cross currency basis - the extra cost of borrowing dollars via the FX swap market compared with what it should be according to interest rate differentials.
USDJPY basis chart
Source: The daily shot
For example, when you add this extra cost of 0.65% (known as the “basis”) to the interest rate differential of 0.85%, the cost of hedging a 10-year US treasury bond via a cross currency swap comes to 1.5%, hardly worth the effort when the bond itself is yielding less than 1.6%.
As the following chart show, those who got in quick have locked in a good yield, but with the basis where it is now, the window of opportunity has closed.
US bond hedged chart
On the other side of the coin, US-based investors can take advantage of the blowout in the basis and buy short term Japanese treasury bills fully hedged at a yield of around 1.25%, way above the return on the equivalent security in the US.
They receive 1.5% by lending dollars in the FX swap market, lose 0.25% because of the negative yield on the treasury bill, and still come out with a net 1.25%.
Japanese notes hedged chart
USDEUR basis is also negative, but at 0.40% not as extreme as USDJPY. A big influence has been US-based corporations issuing bonds in euros and then swapping back into dollars, thus pushing out the basis, in the absence of arbitrageurs on the other side.
On the other other hand the basis is positive in markets like Australia and New Zealand where local interest rates are relatively high and there is little interest in offshore investment. In addition banks are opportunistic borrowers in lower cost offshore markets. The positive basis provides an opportunity for highly-rated entities like the World Bank to issue bonds in AUD or NZD and swap back to USD at sub-Libor.
With the cross currency basis closing down opportunities for global investors to take advantage US bond yields, the temptation will be for Japanese, European and sovereign wealth accounts to buy in on an unhedged basis, providing support for USDJPY and USDEUR. Investors with access to US dollars will be in the driving seat for some time because the big banks no longer have the appetite to drive the basis back down to zero, where the law of covered interest parity says it should be.
For more on forex, click here.
– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.