Strange things have been happening in markets, that much we know.
In the credit world, derivatives linked to the corporate debt sold by companies have been trading at a tighter level than the cash bonds themselves. In the vast and shadowy repo market, the rates charged for interest rate swaps have plunged below equivalent U.S. Treasury yields. Meanwhile, in FX markets, the cost to convert local currency payments from the euro area, the U.K., and Japan into dollars has jumped, sending the so-called “cross-currency” basis deeper into negative territory.
While a sharply subzero cross-currency basis would normally be interpreted as a symptom of a profound dollar funding crunch associated with stressed-out banks trying desperately to hedge their liabilities, this particular bout of negativity appears to be more about massive post-2008 changes wrought on the wider financial system.
Where once banks and other arbitrageurs might have stepped in to profit from and ultimately arbitrage away such dislocations, new rules imposed in the wake of the financial crisis are said to have largely limited their balance sheets and stunted traders’ ability or willingness to eke out the various oddities that have been gripping markets.
When it comes to the cross-currency basis, however, there does appear to be a new arbitrageur in town.
Barclays analysts led by Marvin Bath argue in a new note that: “As banks have faded as constrainers of basis, the new limiter of basis widening—at least for some currencies—has become bond issuers. For issuers, basis represents an opportunity to cheapen funding costs by issuing in a foreign currency in which basis widening has created an arbitrage in issuing conditions.”
In fact, Barclays argues that companies playing in the cross-currency swap market are helping to limit the move in the basis by taking advantage of cheap funding costs to sell debt denominated in foreign currencies.
“Holding basis constant, if U.S. credit spreads widen relative to other currencies, cross-currency issuers will tend to shift issuance outside of the U.S.,” the analysts say. “Holding credit spreads constant, if U.S. dollar basis falls (cheapening non-U.S. interest costs), issuers will tend to shift issuance to the U.S. to lend ‘expensive’ U.S. dollars in exchange for cheaper home-currency funding.”
In other words, as investment-grade credit spreads rise, U.S. companies will sell their debt in Europe for cheaper funding costs and pay to swap the proceeds back into dollars. That dynamic can continue until the interest rate differential—a function of both credit spreads and swap costs—rises sufficiently to offset the funding advantage of issuing in euros.
Indeed, the comparative cheapness of euro funding has already sparked a rush of U.S. companies selling euro-denominated debt. Bank of America Merrill Lynch credit analysts also argued last week that European investors, starving for yield as the European Central Bank (ECB) embarks on more easing, will be forced to seek juicier returns in the U.S. bond market.
“Strong demand by non-U.S. investors for FX-hedged, higher-yielding U.S. fixed income has led to an imbalance of demand in cross-currency swap markets to borrow U.S. dollars and lend foreign currency,” the Barclays analysts write. “Combined with institutional constraints [that have limited the ability of banks to offset cross-currency imbalances], this has led to a widening of basis in favor of U.S. dollar lenders (i.e., negative basis implies higher offshore U.S. dollar interest rates).”
Companies happy to take advantage of cheaper euro funding costs may be one reason why the euro-dollar basis has remained closer to the zero level than other cross-currency pairs. The yen-dollar and Swiss franc-dollar basis, for instance, have both plunged below minus-40 basis points despite the apparent lack of the kind of banking crises that have historically been associated with such bouts of negative basis.
“In the absence of a well-developed corporate bond market, issuers are less of a constraint on basis,” the Barclays analysts said. “This is true of emerging markets, but also of Japan. Because Japan lacks large private sector entities with significant funding needs that would be natural cross-currency issuers, the U.S. dollar/Japanese yen basis is less likely to be constrained by issuance.”