What the Hell Is A Cross-Currency Basis Swap, And Why Do They Matter?

I have spoken a lot about cross-currency basis swaps, but many people may still be wondering what a cross-currency basis swap is and why they should even care? Something that has seemed to confuse many people, especially those who have been more outspokenly bearish on the dollar, is its strength in the face of all the geopolitical and macroeconomic events taking place simultaneously. There is also a lot of talk about all the “money printing” (I hate that term) taking place, and when I state there is still a shortage of dollars, they say are you crazy? In the question to dollar shortage there is a metric to measure that, and it is the cross-currency basis swap.

So what are cross-currency basis swaps? In technical terms, as the BIS puts it, “….In a euro/US dollar swap. At the start of the contract, A borrows X·S USD from, and lends X EUR to, B. During the contract term, A receives EUR 3M Libor+ α from, and pays USD 3M Libor to, B every three months, where α is the price of the basis swap, agreed upon by the counterparties at the start of the contract. When the contract expires, A returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as of the start of the contract.” Now that the technical aspect is out of the way, what is it that they can do? Cross-currency basis swaps can serve two functions: measuring the shortage of dollars, and as a dollar shortage is perceived, a premium (basis) will be added to the swap. So it is first a way to measure dollar shortages and the additional premium to charge as the dollars become more scarce. Thus one could think of it as a way to measure the demand for one currency over another. Chart 1 below shows the simple average of a basket of currencies. One could deduce from that chart now that the basis is lower than it was during the beginning of the pandemic; thus, there is a perceived shortage of dollars. You can also see that when the DXY is weak, the basis moves closer to zero but has never been able to decompress above zero. So from this chart, we can see that there is a perceived shortage of dollars, and cross-currency basis swaps measure counterparty risk. So as Banks are perceived as riskier, an additional premium will be added to the basis swap.

(Chart 1)

As stated above, the cross-currency basis swap can be used to measure risk, and there are implications that a more negative basis has on European Banks. As the BIS says, “…short-term FX swaps is much more sensitive to risk premia and bank funding strains, particularly during crisis episodes.” In Chart 2, as was pointed out by E. Lefeuvre that as bank stocks have fallen, there has been a widening in the basis swap. This could also as the BIS has pointed out be an issue of the inability of European banks during times of crisis to access dollar funding. When they do, the premium (wider basis) would be charged to incorporate increased or heightened risk. There is also a correlation between higher CDS blowouts within Europe if you look at European bank CDS on a five-year tenor, and the cross-currency basis swap inverted as CDS widens within Europe, the basis becomes more negative. This is most likely due to CDS and probabilities of default obviously factor into a more negative basis as bank counterparty credit risk adds a steeper premium on the basis swap. This relation between CDS and Cross-currency basis swaps is shown in Chart 3 below. 

(Chart 2)

(Chart 3)

Next, we will look at Central Bank tightening and its relation to a decompression in the basis swaps or a compression in basis swaps, depending on who is tightening. Again, the credit for that chart, even though I updated it since the last time E. Lefeuvre published it, is the ratio between the FEDs and the ECB’s balance sheet. You can see that as the Federal Reserve grows its balance sheet faster than the European Central Bank, this leads to a narrow basis, and as the balance sheet of the European Central Bank grows faster than the FED, it leads to a wider basis. This can be seen in Chart 4, and with the Federal Reserves’ current projection between the dot plot and expected balance sheet run-off, this basis I am forecasting will widen even further from here. However, I am still expecting a Fed pivot, but with that being said the Fed is moving much more aggressively than the ECB. Thus as we start to see the balance sheet tightening up until December, when I expect a pivot, this will further compress the basis. 

(Chart 4)

In conclusion the cross-currency basis swap is a great indicator to watch for stress credit market wise, and as a way to measure dollar shortage. I am forecasting that the Federal Reserve will eventually be forced to back off of its tightening plan and will drop interest rates again. The dollar funding market is already starting to see a lack of dollars within the system. With the treasury saying they will not be doing any new net issuance, this puts further pressure on the dollar market. With that said, the Federal Reserve, as stated, should end up backing off. If they do not, I worry about the repercussions that could have across the world, and the potential for bank defaults, as many of them require USD to fund their long-term investment portfolios. If you take that away, you start to run into the possibility of contagion within many banking sectors