At the peak of the COVID financial market crisis in March, the Fed opened liquidity swap lines with several other central banks to ease dollar funding pressure.  As these pressures ease, I look at the implications for the FX markets and hedging costs.

In March 2020, US dollar money markets became severely strained, with funding more expensive or difficult to obtain for many borrowers… Stressed conditions were also seen in FX swap markets, with a sharp widening of the FX swap basis across a range of currencies, most prominently in parts of Asia… These developments were accompanied by strong demand for US dollars in spot markets, resulting in a sharp appreciation of the US dollar against many currencies. These pressures then eased to a significant extent following a broad and extensive policy response.

US Dollar Funding – An International Perspective

Bank for International Settlements (June 2020)

It has been argued that the Fed’s decision to open and expand US dollar swap lines was ‘the most important Fed action’  in helping to contain the financial market crisis that exploded in March.  This is a bold claim considering the Fed has also taken interest rates to (effectively) zero, increased its balance sheet by about $2.5 Trillion (almost the size of entire UK economy), and is now back-stopping high-yield bond funds and lending directly to ‘highly rated’ corporations.

While not all of these extreme measures had occurred in March, it is undoubtedly true that the swap line initiative was a critical intervention.  The Fed announced expanded swap lines on March 19th, which effectively corresponds to the low-water mark for both EURUSD and the S&P 500 (Chart I).

Chart I: Expanded swap lines mark the low point for EURUSD (orange) and the S&P 500 (blue)
Source: Bloomberg
Swap-Line Demand is Now Easing

So far it seems the Fed’s strategy of flooding the international markets with dollars has worked.  Data released by the New York Fed last week shows that the usage of these emergency swap lines has declined by about a third since peaking last month (Chart II).  It is also notable that the peak of swap line demand ($450 billion) was significantly below that of the 2008 Global Financial Crisis, when swap line demand approached $600 billion.

Chart II: US Dollar Liquidity Swaps, Amounts Outstanding (USD millions)
Source: New York Fed

The paring back of these swap lines by central banks, in particular the ECB where usage has declined by about $100 billion since late May, reflects a falling demand for the safe haven comfort of USD assets and a general increase in market confidence as the panoply of central bank measures (from the Fed and others) reassured investors that the worst is now behind us. 

Swap-Lines, Cross Currency Basis, and Hedging Costs

US funding pressure and cross-currency basis are two sides of the same coin.  In the past (pre 2008), covered interest rate parity (CIP) ensured that FX forward points reflected the prevailing interest rate differential between two currencies.  If an investor based in a high(er) interest currency (e.g. USD) was hedging an asset in a lower yielding currency (e.g. EUR), then they benefited from ‘positive carry’ that was a mechanical function of this interest rate differential. 

Since 2008, this relationship has been less reliable, especially when it applies to the USD.  The divergence in forward points from the pure interest rate differential is called cross currency basis, and it has proved a consistent tail-wind for USD-based investors hedging EUR and JPY exposures (among others) for the last decade (Chart III):

Chart III: EURUSD Cross-Currency Basis (3 Month, bps)
Source: Bloomberg

There are three main reasons why this basis (in effect an ‘excess demand’ for US dollars as long as the basis is negative) exists:

1. Bank funding gaps

When banks have mismatches between their domestic currency depositor base and the demand for international loans, they will hedge this using FX swaps.

2. Strategic hedging by institutional investors

Investors such as pension funds, insurance companies and private capital managers will seek to manage currency risk arising from international investments.

3. Debt issuance from non-financial firms

Where corporations borrow internationally and opportunistically, they seek to hedge out the currency risk in the swaps market. 

If we look at EURUSD, the basis has been consistently negative since 2008, primarily because of factors two and three. European institutional investors have increasingly been pushed towards USD-denominated assets as eurozone assets have underperformed.   In addition, US non-financial firms have been issuing (and hedging) more debt in euros as corporate credit spreads have fallen relative to the US dollar bond market (as a consequence of the ECB bond purchase programmes). 

This market anomaly has made the USD ‘cheaper’ for long-duration hedgers and created a favourable environment for those ‘going against the grain’ (either USD-based investors in euro assets, or EUR-based borrowers of USD) providing a hedging tail-wind which has averaged about 30 annualized basis points since 2008.

One of the interesting consequences of the recent Fed actions is that the EURUSD cross currency basis flipped from negative to positive (Chart III) for the first time as ‘borrowing’ dollars through the FX swap market became temporarily cheaper than direct funding in the dollar cash market.

Implications for FX Hedging

The issue of US dollar-funding stress and cross-currency basis is a technical one, and can seem a little abstract compared to some of the issues we normally focus when looking at the currency markets, such as relative economic growth and monetary policy.  However, there are two important implications for international investors (and hedgers):

FX Markets (Spot Rates):

First of all, cross-currency basis is an important indicator of US dollar demand, particularly in times of stress, as one of the key sources of support for the US dollar is its safe haven appeal.  If the Fed’s swap lines are believed to be a consistent and reliable tool to address this issue, then this could be seen as a bearish indicator for the dollar, as it would imply that such crisis-related spikes in USD demand would be less likely in the future.

While this is a key reason why the US dollar has weakened since March (Chart I), I remain sceptical of this thesis.  Swaps, as many readers will know, are a mechanism to adjust timing, rather than notional amount (i.e. demand).  Whilst the Fed swap lines were very effective at addressing the short-term liquidity shock we saw in March, the overall long-term demand for US dollars has not changed (which is primarily a function of unhedged international US dollar liabilities).   In other words, while Fed swap lines may alleviate the symptoms, they cannot cure the disease.   (Note: the broader issue, about whether there is a structural ‘short’ USD position that exists as a result of foreign debt issuance in US dollars, is probably the biggest, and most controversial, debate between US dollar bulls and bears today. There are persuasive arguments and advocates on both sides.  Those who argue that this structural short position exists feel there is another leg higher for the US dollar, while those who feel it is illusory claim we have entered a US dollar bear market).

Hedging Costs (Carry):

Carry has already declined significantly, especially for EURUSD.  The fact that cross-currency basis spiked into positive territory in March for the first time ever must be considered a red flag for USD investors accustomed to benefiting from the arbitrage-like conditions of positive carry (in effect being paid to hedge).    Whilst the basis has since dropped back (marginally) below zero, it is worth re-evaluating hedging policy frameworks, particularly those which rely on using long-tenor hedging to capture the positive carry. (Note:  Cross-currency basis currently represents between 10% and 15% of total carry in EURUSD).

Similarly, for euro-based investors who have traditionally been reluctant to hedge USD exposures due to negative carry, it is worth ensuing that the hedging capability is there to act tactically as opportunities arise to hedge cheaply.

Author: Kevin Lester