Making Negative Rates a Positive

Cross-currency basis swaps can be used to generate healthy returns out of minus signs.

Who in their right mind would pay to park their money in Europe or to invest in the bonds of Japan, the world's most indebted developed nation?

Actually, anyone who could swap it into U.S. dollars. Using a financial instrument called a cross-currency basis swap, German and Japanese two-year notes can pay more than Treasuries.

According to a Feb. 18 research report by Citigroup analyst Matteo Regesta, if swapped into floating dollar rates, an investment in two-year bunds pays 15.5 basis points over Libor, almost 20 basis points more than the same investment in Treasuries. A similar application applied to Japanese government securities pays 71.2 basis points, 75.5 basis points more than U.S. government debt.

Thank free capital flows for the oddity. As money exits Europe and Japan in search of higher rates in dollars, cash flows have to be exchanged and hedged in the U.S. currency, moving the cross-currency basis swap. That makes it more attractive to invest in those same nations and receive the proceeds in dollars. For every financial transaction, there are two sides of the trade, after all. Adding pressure on one side increases the allure of the other.

Circular Argument

As investors flee negative rates in Europe and Japan, swaps drop, making bunds and JGBs more attractive

Source: Bloomberg

The same dynamic would also in theory make it more attractive for companies in Japan and Europe to sell dollar-denominated bonds and swap the proceeds back into their home currency. If they evaluate the cost of funding on a Libor basis, as most issuers that sell debt in various currencies do, they may see an advantage to borrowing in dollars even as domestic benchmark rates move into negative territory.

Global investors have been pulling money out of Japan at the fastest pace since May 2014 as the yen strengthened and the Bank of Japan turned to negative rates to spur growth:

Pulling Out

Foreign investors have been taking profits on Japanese investments, adding to pressure on swaps

Sources: Bloomberg; Japan Ministry of Finance

In Europe, the most foreign capital exited stock markets from the 19 euro nations since December 2011:

Run for the Hills

Stock investors are pulling money from the euro zone's 19 member states at the fastest pace since 2011

Sources: Bloomberg; European Central Bank

The sheer amount flowing out of those two markets is only serving to increase the reward for those brave investors who opt to swim against the tide. At the same time, it's become more expensive for Japanese investors to swap their yen into dollars and park those dollars offshore. That in turn works to stop the yen from depreciating further, something that could help spur growth.

Financial Mirage

While it seems like returns on U.S. dollar bonds are higher, once swaps are applied, that's not true

Source: Bloomberg

In a historic address to the U.S. Senate in February 2005, then Federal Reserve Chairman Alan Greenspan spoke of a conundrum facing policy makers regarding the market's response to central bank moves. Cross-currency basis swaps are adding a whole new dimension to that.

In a recent speech, Adair Turner,  chairman of the U.K. Financial Services Authority until it was disbanded in 2013, said that central bankers can no longer trust low interest rates to spur growth. Printing physical money may be the only way to spark expansion and, ultimately, inflation, he said. 

Perhaps that idea isn't so far fetched. Creative finance can be limited by hard cash.  In the meantime, so long as swaps allow it, investors will continue to get back into those same securities central banks in Europe and Japan are trying to force them to sell.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at

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    Katrina Nicholas at

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