Cross-Currency Swap Premium Rises Amid ECB Rate Cut Speculation

The premium that European lenders pay to obtain dollar-denominated cash flows increased to an almost eight-month high amid speculation the European Central Bank will increase monetary stimulus tomorrow.

The rate on a three-month cross-currency basis swap between euros and dollars was negative 10 basis points, the largest negative since Oct. 8 on a closing basis, according to Bloomberg data. A negative swap rate signals traders are paying a premium to trade euro-based cash flows for comparable flows denominated in dollars.

ECB policy makers, who meet tomorrow, are debating a cut of 10 or 15 basis points in both the benchmark and deposit rates, according to two euro-area central bank officials who asked not to be identified. Policy makers will cut the deposit rate to negative 0.1 percent from zero, according to 32 of 50 economists in a Bloomberg survey.

“Expectations of ECB easing have already weakened the euro and led to a widening of the euro-U.S. dollar cross-currency basis,” Brian Smedley, an interest-rate strategist at Bank of America Corp. in New York, wrote in a note to clients published May 30. “A bank that prefers to hold reserves at the Federal Reserve for 25 basis points rather than hold reserves at the ECB at negative 10 basis points or lend cash in the interbank market could instead swap euros for dollars. This activity would cause the swap basis to widen until there is no longer an incentive to swap euros into dollars.”

The ECB benchmark rate was left unchanged at 0.25 percent at its previous meeting on May 8, and the deposit rate was held at zero. The Fed has paid 0.25 percent on excess reserve banks hold at the central bank since December 2008.

Foreign-exchange swaps are typically for periods of less than a year, while cross-currency basis swaps usually range from one to 30 years. The latter are agreements in which a person borrows in one currency and simultaneously lends in a different currency. The trade involves the exchange of two different floating-rate payments, each denominated in a different currency and based on a different index.

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