The World's New Fear Gauge Is Ringing Alarm Bells in the Era of Trump
Once upon a time, the cost to hedge currency risk in global trade and finance was relatively cheap. How things change.
In the pre-crisis heyday, when the cost to procure dollars staged an uptick — implied interest rates in the currency market exceeding corresponding rates in the cash markets by a notable margin — banks would subsequently arbitrage away the difference, and move the gap close to zero.
Once viewed as a law of finance known as the covered interest rate parity condition, this market dynamic unraveled during the global financial crisis and then again during the euro-area sovereign debt debacle, amid a spike in counterparty risk and a sharp reduction in dollar funding to non-U.S. banks. These two strains — a key barometer for risk appetite and financial stability — have eased relative to the heights reached during the crisis.
Now a bevy of forces, including banks continuing to downsize balance sheets and money market reforms, have conspired to increase the structural costs of currency hedging relative to the pre-crisis heyday. And things just got notably worse.
As the U.S. dollar surged in the wake of the U.S. election, cross-currency basis swap spreads have been strained. In short, investors in the yen and euro seeking to hedge their dollar obligations are now forced to pay an effective Trump premium.
The Fed's trade-weighted dollar index rose by 3.9 percent between Nov. 8 and Nov. 29. Over the same period, the cross-currency basis widened for all Group of 10 currencies, led by the yen.
In a paper for the Bank for International Settlements released last month, researchers led by Stefan Avdjiev highlighted how the dollar is a key driver of bank balance sheets, effectively dethroning the CBOE Volatility Index (VIX) as a benchmark for market fears. The stronger the dollar, the wider the deviations from covered interest parity (CIP), slowing down cross-border bank capital flows in dollars, the analysts noted.
In a research note published on Monday, the authors updated their data and found that the evidence from the post-election period confirms the original findings.
"For the post-election period, the 'dollar beta' is defined as the ratio of the change in the cross-currency basis (in basis points) over changes in the broad dollar index (in percentage points)," the analysts write. "In line with the findings in Avdjiev et al (2016), the dollar beta is highly correlated with the basis itself. The correlation coefficient is 98 percent."
In other words, the rise in the cross-currency basis is correlated with dollar strength so that when the greenback surged, CIP deviations widened. So look to the dollar and cross-currency basis swaps in the months ahead to observe risk-appetite among global banks.
The rising costs to hedge currency risks isn't just an issue facing levered fixed-income investors in developed-rate markets. Dollar shortages in Asia loom next year, a headwind for trade and financial transactions, according to analysts citing, in part, an uptick in cross-currency basis swap spreads.