Notes on stresses in USD funding markets and prices implied in Cross Currency basis swap

The cost of raising U.S. dollar funds in the euro swaps market rose sharply this year. Sterling, yen FX basis swaps have surged as well.

"Financing Airbus, that is in dollars. If French banks won't do it, will it be JP Morgan? Or will it be no-one?" Would it, in other words, hurt French banks' market share and handicap French companies doing business overseas because the cost of financing in dollar is rising?

The rising cost of dollar has tremendous implications in a world where the dollar remains the dominant currency in financing trades and FX trading. So far this year, according to the BIS, the US dollar was on one side of 88% of all FX trades while the share for the euro is at 31%. Those for the Japanese yen and the pound sterling are at 17% and 13%, respectively.

Cross currency swaps allow investors to raise financing in a particular currency from the major funding markets. For example, an institution with dollar funding needs can raise euros in euro funding markets and convert the proceeds into dollar funding obligations via an FX swap. These swaps enable, for example, banks that have raised funds in one currency to swap those proceeds (and their subsequent interest payments) in another currency over a finite period – thereby broadening the availability of funding to cover multiple currency markets. In the EUR/USD swap market, the so-called “basis” is the premium paid by market participants to obtain US dollar funds.?

Normally, the premium is calculated as the difference between the US dollar interest rate implicit in the swap and the unsecured US dollar interest rate. Prior to the financial crisis in 2008, many international banks, including European banks, used unsecured US dollar funding as an attractive alternative source of funding. The favourable funding conditions in US dollars reflected the size of the wholesale US dollar money market and the fact that unsecured funding was also available for longer money market maturities than in, for example, the euro money market. European banks active on the market often raised more USD-denominated funds than needed and therefore swapped back their US dollar surplus into their domestic currency. At that time, the cost of swapping euro into US dollars, as measured by the EUR/USD basis swap, was essentially zero, meaning that the cost of funding in US dollars was in line with the US dollar LIBOR and that there was no particular imbalance in the demand for US dollars or euro from market participants.?

In such calm environments, an American buying US Treasury bills earns the same return as an American buying German government bills hedged into dollars. She buys 10y UST Bond, so receives 10y yield and when she hedges FX risk of this bond for 3 months tenor, she would essentially be paying USD 3 month (FX implied) rate and receive 3 month EUR rate (assuming investor is funded in EUR or is EUR based.) The exchange rate between dollars and euro three months in the future should be the exchange rate today adjusted for the interest you can earn holding dollars and euro for three months. The short-term interest rate differentials implied from the overnight index swap markets and the currency markets should be in line according to this proposition. This is called covered interest parity (CIP). And whenever the yield on a US T-bill hedged into euro (EUR/USD Cross Currency basis) is below the yield on short-term German government debt, a negative basis spread scenario, profitable opportunities arise within this framework.

However, in reality the negative, or positive, basis can persist for a long time. A combination of new leverage rules that limit the ability of banks to take the other side of such trades plus changes to US money-market fund regulations that make it more difficult for foreign banks to raise dollars is one force responsible for such phenomenon. A similar combination of forces interacted with strong Japanese demand for US assets hedged into yen have created persistently wide USD/JPY basis in the recent years.

A related note. USD can be funded domestically or in international funding markets. These two funding markets create natural links between Interbank lending rate-OIS spreads and Cross Currency Basis. In general, these two have moved in the same direction. When the former widens (which is “long-term” unsecured USD interbank funding getting more expensive versus overnight funding), then the Cross Currency basis also widens – i.e. moves more negative, as USD funding collateralised with foreign currency replaces domestic USD funding sources. The Cross Currency basis as measured by XOIS (USD OIS vs foreign currency OIS) has therefore tended to be more stable/less volatile than the interbank lending rate-based equivalent.

Since the financial crisis and following the introduction of regulatory changes impacting US money market funds (historic provider of US short-term funds), the EUR/USD basis in the FX swap market became negative from time to time, most notably in January 2010. Such instances underscore a structural force that veers euro area banks to borrow US dollars via the FX swap market. Indeed, following the reduction in interbank unsecured lending at the start of the financial crisis, banks had to make greater recourse to FX swaps to fund their US dollar liabilities. After the bankruptcy of Lehman Brothers, the FX swap market became impaired – as did several other market segments – and banks became highly concerned about counterparty risks. Within the resulting struggle to reduce bilateral exposures, it became difficult and expensive to obtain US dollars via FX swaps and the EUR/USD basis swap widened significantly. In October 2008, the US dollar rate implied in short-term FX swaps reached 200 basis points above LIBOR in the three-month segment.

During 3Q 2022, three-month euro cross-currency swaps recently hit 55.5 basis points, the highest since mid-March 2020, the beginning of the coronavirus pandemic, as foreign banks and companies scrambled for dollar funding. In other words, investors were willing to pay around 55.5 basis points over interbank rates to swap three-month euros into dollars. A few weeks ago, that three-month cost was 21 basis points and it was 8 basis points only a few months back.

Concerns about, well, violent jump in borrowing costs, illiquidity observed in government bond market, and the ongoing Russia-Ukraine war to name a few, have filtered to U.S. dollar funding market. On the cusp of the war, according to estimates by a Credit Suisse analyst, Russia held about $300 billion in short-term money market instruments: $200 billion in FX swaps and another $100 billion through public and private deposits. The move by the United States and its allies to block Russia from using $630 billion in central bank foreign currency reserves since have made dollar funding costs expensive for Western companies who were getting paid by Russian counterparties. Or many emerging market countries that might have to face a funding crisis as local banks will likely struggle to pay back external debts denominated in dollar maturing over the next months.?

Another case in point, the Korean won once fell about 15 per cent against the dollar over a span of a few months when investors started to worry that the country may run short of dollars to pay back debts amid plunging exports and that overseas lenders may withdraw money en masse ahead of yearly book closing.?Whenever doubts grow over whether local banks have enough foreign currency funds to pay back short-term foreign debts due, it could spiral to a sovereign-level funding stress. To stem further funding market crisis, central banks keep an close eye on the market and step in to provide dollar liquidity when they see it's necessary.

As the only institution that can create dollar liquidity, the Fed acts as an international lender-of-last-resort in a market that uses the dollar as its key currency. The Fed has several mechanisms in place that could provide relief for short-term funding markets such as FX swap lines. The Fed maintains standing FX swap lines with a number of central banks, including the Bank of Japan, European Central Bank, Bank of England, Bank of Canada, and the Swiss National Bank.

A strengthening of US dollar has had adverse impacts on bank balance sheets, and reduced banks’ risk bearing capacity. Wider CIP deviations and lower dollar-denominated cross-border bank lending both reflect a higher price of bank leverage as a result of a stronger dollar. (If ever conjured albeit hard to imagine with its continued appreciation with earth-scorching force, dollar depreciation should make the whole process work in reverse. It could also alleviate some of the demand-side pressures. For example, Japanese investors in dollar-denominated assets may decide to reduce their hedging as the yen appreciate.)

Several other funding market gauges are flashing alarm. The spread between the U.S three-month forward rate agreement and the three-month overnight index swap rate, a key funding stress indicator, rose to 23.75 basis points, the highest since May 2020. The higher spread reflects rising interbank lending risk or dollar hoarding.

Changes in laws, not only bank creditworthiness, can squeeze dollar funding pipelines between the US and the rest of the world. Strange moves in markets are, at times, attributed to structure, not financial stress, until they will eventually reverse themselves. An earlier example of this was in late 2016, when money-market fund reform led investors to move $800bn out of commercial-paper prime funds into Treasury government funds. That led to a wider cross-currency basis swap and wider Libor-OIS spreads.

A quantitative tightening (QT) program can also impact the FX swap spreads. The Fed has embarked on a quantitative tightening (QT) program, meant to drain pandemic-era stimulus from the financial system. (As it continues with QT, its balance sheet remains huge at $8.759 trillion, as of 3Q 2022.) Quantitative easing (QE) during the pandemic expanded the Fed's balance sheet by trading Treasury and other securities for cash, boosting bank reserves deposited at the central bank as well. When the Fed embarked on QT, the expectation was that bank reserves held at the Fed would decline. The decline in bank reserves has been more rapid than what some had anticipated. Bank reserves at the Fed fell under $3 trillion to $2.972 trillion, down roughly $1.3 trillion from a peak of $4.3 trillion in December 2021. In the Fed's previous QT cycle, $1.3 trillion in liquidity was withdrawn in five years.

The decline in bank reserves makes it harder to trade currency and therefore affect the movement in the basis. Given banks keep their liquidity with the sovereign, not other banks, and reserves, not interbank deposits are the system’s main settlement medium. When the amount of reserves declines, banks increase their reliance on repos to settle. The more the banking system relies on repos to settle FX swap trades, the farther FX swap implied rates drift from the OIS curve and the wider the cross-currency basis.

If the net supply of U.S. Treasuries will increase by over $1 trillion, and foreign FX hedged buyers will have to buy a large portion of this supply. But the curve is currently inverted relative to hedging costs, and foreigners won’t increase purchases unless the curve re-steepens relative to FX hedging costs. In other words, cost of hedging needs to come down to be an attractive entry point. (For the 10-year to be attractive relative to other G7 bonds on a hedged basis, yields would have to back up to at least 3.5% and more realistically to 4.0%; alternatively, three-month FX hedging costs would have to come down to 2.0%, either through positive cross-currency bases, much lower bill yields or rate cuts, according to a Credit Suisse analyst.) Some foreign accounts’ mandates do not allow for much of any FX risk and so hedging costs have a big impact on whether foreign private investors buy U.S. Treasuries or other bonds available globally. (The U.S. government will have to focus on how to entice price sensitive foreign investors to fund the growing federal deficit on the margin. The impact that rate hikes have on FX hedging costs and the slope of the Treasury curve relative to the slope of other core government curves globally should be taken into account when thinking about the country's funding needs.)

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