l a i c e p S | y g e t a r t S s e t a R S U
Please see the last page of this publication for important disclosures.
August 29 2011
Cross-Currency Basis Swaps: The Supply Effect
The EUR/USD currency swap is being used by European financial institutions to fund USD assets when repo lines or raising USD through commercial paper, CDs, or other funding sources becomes too expensive or inaccessible (borrowing dollars). This market is showing signs of funding stress which we look at in some detail below.
European corporations, agencies, supranationals and sovereigns use the cross-currency basis swap to swap USD issuance back into Euro (lending dollars).
The EUR/USD cross currency basis swap is currently attractive for European issuers looking to issue in dollars and swap it back to euros. For instance, as highlighted below, some issuers could do this and improve their funding levels by over 40 bp.
The attractive levels could prompt USD issuance to fund the European bailouts, and if this occurs, we expect the basis to narrow.
An increase in the use of the Fed and ECB’s swap lines could also narrow the basis.
The main factors that have resulted in a more attractive basis swap include European bank funding concerns, demand for USD from European financial institutions, and a decline in USD issuance from European corporate and SSA issuers.
Potential Source of New European USD Supply
Eric Hiller
Head of Derivatives Strategy +1 203 897 2652
[email protected]
Ryan Graf
Rates Strategy +1 312 664 7085
[email protected] www.rbsm.com/strategy Bloomberg: RBSR
Our European strategists continue to expect the lending capacity of the European Financial Stability Facility (EFSF) to increase from EUR 256 subject to parliamentary approval bn to EUR 440 bn 1 . The increase is subject in the EU which is expected to be completed by the end of September or the beginning of October at the earliest. Our European strategists currently think about 25% of the issuance could be in USD which would equate to as much as $158 $158 bn at current FX rates. rates. The exception would be if EFSF issuance ended up being fairly low (i.e. EUR 50 bn or less). As we outline below, the cross currency basis makes USD issuance relatively more attractive for EFSF and other European issuers. issuers. If they 1
See The All New and Improved EFSF by our European strategists for more details.
The Royal Bank of Scotland
are able to fund in USD at similar local spreads, current basis swap levels would makes it very attractive for the EFSF to ramp up USD issuance. In addition, it is highly likely that such issuance and the swapping activity would push the currency basis back toward less stressed levels. Longer Tenor Cross Currency Swaps Affected by Issuance
Longer-term cross currency basis swaps are strongly related to sup ply and demand of USD and have been less volatile than shorter maturity basis swaps as seen in figure 2. In fact, the longer term EUR/USD basis swap levels closely track USD issuance from European corporations and SSA as highlighted below. When a European issuer issues in USD and uses the basis swap to convert the USD into EUR, it supplies USD to European financial institutions causing the basis to become less negative. The lopsided demand for USD funding drove the basis negative and an offsetting flow from issuers would reduce the supply/demand imbalance.
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
Figure 1: Yankee issuance from Euro area corporations and SSA has had a tendency to push the term EUR/USD basis closer to zero 50
0
45
-5
40
-10
35 ) n b $ ( e c n a u s s I
-15
30
-20
25 -25
20
-30
15 10
-35
5
-40
0
A v g M o n t h l y B a s i s S w a p L e v e l ( b p )
-45 Jan-10 Issuance
Apr-10
Jul-10
Oct-10
Avg 3yr EUR/USD Basis Swap
Jan-11
Apr-11
Jul-11
2M Moving Avg. (Issuance)
Source: RBS, Dealogic, Bloomberg
2
The Royal Bank of Scotland
Figure 2: The EUR/USD basis provides a funding advantage to Yankee issuers which has varied with time and time to maturity
20 0
) s p b ( s i s a b D S U /
-20 -40 -60
R U E
-80
26-Nov-10 26-M ay -11
28-Feb-11 26-A ug-11
-100 0.0
2.5
5.0
7.5 10.0 12.5 15.0 17.5 20.0 22.5 25.0 27.5 30.0
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
Maturity (years) Source: RBS
Fed Swap Lines Affected the Basis
Another factor which affected the basis in the past was the Fed’s USD swap lines with foreign central banks. As part of its effort to deal with the liquidity crisis of late 2008, the Fed ramped up its USD swap lines with foreign central banks, and open lines reached almost $600 bn at the peak. This led to a normalization of the cross currency basis to pre-crisis levels. If the current funding situation were to worsen, USD from the Fed’s central bank swap lines could collapse the basis. Figure 3: Fed Swap Lines versus 3m EUR/USD Basis Swap 700
0 -20
600 ) n b $ ( s e n i L p a w S D S U d e F
-40 500
-60 -80
400
B a s i s S w a p ( b p )
-100 300
-120 -140
200
-160 100
-180
0 7 /2 /0 8
-200 9 /2/ 08
USD Swap Lines
1 1/ 2/ 08
1 /2 /0 9
3 /2 /0 9
5 /2 /0 9
7 /2 /0 9
9 /2 /0 9
1 1/ 2/ 09
EUR/USD 3m
Source: RBS, NY Fed, Bloomberg
Benefiting from the Wide Basis
For European issuers, the benefits of issuing in USD and utilizing the basis swap include diversification of funding and potentially more attractive funding levels. Whether or not it ultimately makes sense for a European issuer to issue in USD depends not only on where the basis swap is but also funding levels in each currency. For example, by 3
The Royal Bank of Scotland
issuing in USD and using a basis swap to convert to EUR, the European Investment Bank (EIB) can currently recognize a 44 bp funding advantage over where their 5yr EUR debt is trading as seen below 2 . Figure 4: A Cross Currency Funding Example with EIB 5yr Levels Spread (bp)
USD
EUR
EUR Eqivalent of USD Funding Level
Libor + 5 bp
Euribor + 5 bp
Euribor - 39 bp Source: RBS, NY Fed, Bloomberg
Figure 5: Steps to Convert USD Funding to EUR Funding 1) Issuer sells a USD debenture 2) If fixed rate, issuer uses a vanilla USD interest rate swap to convert those cash flows to floating rate (3mL + spread)
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
3) Cross-currency basis swap converts USD 3mL payments to 3m Euribor + spread 4) A Euribor 3s6s basis swap converts 3m Euribor + spread to 6m Euribor + spread 5) All of these swaps can be done as one transaction
Source: RBS
EFSF has issued three EUR deals to date totaling EUR 13 bn, but it is unclear where USD debt would trade. In EUR, 5yr EFSF currently trades at Euribor + 8 bp or 3 bp wider than EIB. A similar spread in USD would imply a level of L + 8 bp. This level would represent a significant funding advantage for EFSF as it equates to Euribor – 35 bp. Turning this around, it also means that EFSF (and other European issuers could issue at significantly wider levels in dollars than in euros and the funding would still be attractive.
What does the basis tell us a bout funding stress?
One of the main drivers of the 3m EUR/USD cross currency basis swa p is USD demand from European banks or other institutional investors. These investors need to fund USD assets but repo lines or raising USD through commercial paper, CDs, or other funding sources may be too expensive or inaccessible. While these institutions could sell EUR, buy USD and own the assets, this would instantly convert a credit decisi on into a major currency risk. Instead, these institutions turn to the FX market, selling euros for dollars on a spot basis and simultaneously selling the dollars back at a future date in an FX swap. This lets the institutions fund dollar assets until the forward rolls off or assets mature or are sold. EUR/USD Basis Swap Mechanics To borrow USD, one can enter into a 3m FX swap (or a 3m cross currency basis swap which is effectively the same). The institution sells 2
Note: The cross currency basis swap converts 3m Libor to 3m Euribor. Spreads to Euribor for EUR bonds are spread to 6m Euribor. Thus, the Euibor 3s6s basis swap also contributes to the funding advantage.
4
The Royal Bank of Scotland
EUR and buys USD spot and also agrees to the unwind 3-months la ter. Given that the market is overflowing with institutions trying to raise dollars in the same direction, the forward foreign exchange transacti on occurs at a less attractive effective funding level. Parity arguments suggest that the effective cost is supposed to reflect the funding differential (actually the discount function ratio) derived from US and EUR rates. However, the actual funding rates are not equivalent to Libor and Euribor, so the basis, which is described as a spread on th e Euribor side versus Libor flat, is not zero. Thus, the basis swap level reflects the value of a money-market account in one currency divided by the money-market account in the other currency w hich is then converted back into a spread to Euribor. The single period crosscurrency basis is the relative difference in funding rates as follows: If e = Euribor and u = US Libor (both in percent) then the usual assumption for the basis swap spread, x, in percent (for a T day period) is the following:
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
(1+u*T/360)*eur/eurfwd = (1+(e+x)*T/360)
In words, I give you a dollar on the spot date versus euros, and yo u agree to pay me back the same number of dollars plus interest computed at Libor. I agree to give you back the same number of euros plus interest computed at Euribor plus a spread. Economically, I should be indifferent whether we enter a basis swap or an FX swap which means that the basis swa p spread x neutralizes the effe ct of the rate settings and the effective funding in the currency swap. An FX swap also converts dollars to euros at the spot rate and then converts the euros back to dollars a new rate when the swap ends (the new rate is the forward rate at the time the swap is entered into). The FX swap expresses the economics in a drop instead of an interest rate spread. One difference however, is that the market drop reflects the fact that the borrowing of USD does not happen at “u” nor the lendin g of EUR at “e” but at two other effective rates u’ and e’. Thus, the FX swap reflects actual funding rates that can vary signi ficantly from Libor and Euribor. eurfwd/eur = (eur + drop) / eur = (1+u’*T/360)/(1+e’*T/360) = 1 + (u’e’)*T/360 + higher order terms.
With these two expressions we can compute the 3-month basis spre ad from the 3-month drop. Putting it in terms that translate directly into Bloomberg functions and custom expressions, the basis spread x, in basis points is: X = 10000 * (((1 + US0003M Index * 92 / 36000) * EUR Curncy / (EUR Curnc y + EUR3M Curncy / 10000) - 1) / (92 / 360) - EUR003M Index / 100)
5
The Royal Bank of Scotland
Where EUR3M is the 3-month FX drop and T was set to an average da y count of 92 days as an approximation for the 3-month period 3 . The same basis expression can easily be computed versus USD OIS and Eonia by replacing US0003M with USSOC and EUR003M with EUSWEC. The basis to the OIS curves is significan tly smaller which may better focus the attention on the source of the distortion—Libor or Euribor and the remaining bias to receive dollars. Figure 6: EUR/USD Basis Swap (Calc ulated with Libor and Euribor)
Figure 7: Implied EUR/USD Basis Swap spread to Eonia versus OIS 0
0 -10
-10
-20
-20 -30
-30 ) p b ( d a e r p S
) p b ( d a e r p S
-40 -50
-40 -50
-60
-60
-70
-70
-80
-80
-90 Jan-10
Apr- 10
Jul-10
Oct-10
Jan-11
Apr- 11
Jul-11
Source: RBS
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
-90 Jan-10
Apr-10
Jul-10
Oc t-10
Jan -1 1
Apr -11
Jul-11
Source: RBS
Moving from a 3-month basis swap (or FX swap) to the longer tenor basis swap
Adding periods to the basis swap appends a forward starting version of the above calculation. The forward discounting rates embed a pair of FX forwards which is economically converted into a spread to the Euribor side. The mid-market basis spread is the spread that brings th e total value of the multiple cash flows to zero. For a 3-month period, the FX swap market tends to be more liquid than the currency basis. For much longer-terms or mu ltiple resets, the cross-currency basis swap tends to be much more convenient and converts the full economics into a spread to funding.
3
This expression can be used to generate a custom Bloomberg index. However, Bloomberg’s historical convention defaults for cur rencies must be set to display points rather than outrights. To ensure this, on PDFN , under the “Defaults only apply to CURRENCIES” section, set the Forward Rates option to 1.
6
The Royal Bank of Scotland
Contributors John Briggs
Treasury Strategist
(203) 897-4689
[email protected]
Michelle Girard
Senior US Economist
(203) 897-2818
[email protected]
Ryan Graf
Agency Strategist
(312) 664-7085
[email protected]
Eric Hiller
Head of Derivatives Strategy
(203) 897-2652
[email protected]
Margaret Kerins, CFA
Head of Agency Strategy
(312) 664-7085
[email protected]
Jim Lee
Head of Short Term Markets and
(203) 897-4652
[email protected]
Futures & Options Strategy Natan Magid
Short Term Markets Strategist
(203) 897-4666
[email protected]
William O’Donnell
Head of Treasury Strategy
(203) 897-9803
[email protected]
John Richards
Head of Strategy, North America
(203) 897-9430
[email protected]
Omair Sharif
US Economist
(203) 897-2818
[email protected]
1 1 0 2 9 2 t s u g u A | l a i c e p S | y g e t a r t S s e t a R S U
Copyright ©2011 RBS Securities Inc. All rights reserved. RBS Securities Inc. member FINRA/SIPC, is a subsidiary of The Royal Bank of Scotland plc. RBS is the marketing name for the securities business of RBS Securities Inc. The author of this material is an economist, desk strategist, salesperson or trader and will be compensated based in part on the author’s own performance, the firm’s performance and the perform ance of the sales or trading desk for which the author works. This material is informational only, and is not intended as an offer or a solicitation to buy or sell any securities or other financial instruments. It is not considered research and is not a product of any research department. RBS Securities Inc. is not, by making this material available, providing investment, legal, tax, financial, accounting or other advice to you or any other party. RBS Securities Inc. is not acting as an advisor or fiduciary in any respect in connection with providing this information, and no information or material contained herein is to be construed as either projections or predictions. Past performance is not indicative of future results. RBS Securities Inc. transacts business with counterparties on an arm’s length basis and on the basis that each counterparty is sophisticated and capable of independently evaluating the merits and risks of each transaction and that each counterparty is making an independent decision regarding any transaction. Counterparties must make their own independent decisions regarding any securities, financial instruments or strategies mentioned herein. This material is intended for institutional investors only and should not be forwarded to third parties. RBS Securities Inc., its affiliates, and/or any of their respective employees, clients and officers, including persons involved in the preparation or issuance of thi s material, act as a market maker for or deal as principal in the financial instruments mentioned and may have a long or short position in, or engaged in transactions in, these financial instruments. As part of the sales or trading desk, the author may have consulted with the trading desk while preparing this material and the trading desk may have accumulated positions in the financial instruments or related derivatives products that are the subject of this material. Accordingly, information included in or excluded from this material is not independent from the pr oprietary interests of RBS Securities Inc., which may conflict with your interests. Except as to securities issued by the U.S. government and debentures issued by government-sponsored enterprises, RBS Securities Inc. does not permit the author of this material to hold, or engage in transactions in, the securities or other financial instruments discussed herein in any personal account of the author or a member of the author’s household. Certain transactions, including those involving fu tures, options, derivatives and high yield securities, give rise to substantial risk and are not suitable for all investors. Foreign currency denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of or income derived from any investments discussed herein. Unless otherwise specifically stated, all statements contained herein (including any views, opinions or forecasts) are as of the date indicated only, and are subject to change without notice. Changes to assumptions made in the preparation of such material may have a material impact on returns. RBS Securities Inc. does not undertake a duty to update this material or to notify you when or whether the analysis has changed. While the information contained in this material is believed to be r eliable, no representation or warranty, whether express or implied, is made and no liability or responsibility is accepted by RBS Securities Inc. or its affiliates as to the accuracy or completeness thereof, except with respect to any disclosures relative to RBS Securities Inc. and/or its affiliates and the author’s involvement with an issuer that is the s ubject of this material. RBS Securities Inc. makes no representations that this ma terial or any information contained herein are appropriate for use in all locations or that transactions, securities, products, instruments or services discussed herein are a vailable or appropriate for sale or use in all jurisdictions, or by all investors or counterparties. Investors who receive this material may not necessar ily be able to deal directly with RBS Securities Inc. and should contact the RBS Securities Inc. entity or affiliate in their home jurisdiction unless governing law permits otherwise. Those who utilize this information do so on their own initiative and are responsible for compliance with applicable local laws or regulations. This material is made available in the European Economic Area ("EEA") by The Royal Bank of Scotland plc, which is authorized and regulated by the Financial Services Authority (FSA). RBS Securitie s Inc. distributes this material in the U.S. With respect to the execution of interest rate derivatives, credit derivatives and foreign exchange transactions, RBS Securities Inc. genera lly acts as agent for RBS which will be the principal in such transactions. This website and its contents have not been reviewed by any regulatory authority in Hong Kong. RBS Securities Inc. does not conduct, nor holds itself out as conducting a business in investment advisory or dealing services in Hong Kong, nor any other regulated activity. It holds no Hong Kong regulatory licenses. This material is distributed in Singapore by The Royal Bank of Scotland plc (Singapore branch), Level 26, One Raffles Quay, South Tower, Singapore 048583, which is regulated by the Monetary Authority of Singapore. In Singapore, this material is intended solely for distribution to in stitutional investors, accredited investors, and expert investors as defined under the (Singapore) Financial Advisers Act, Chapter 110. Persons receiving this material in Singapore should contact The Royal Bank of Scotland plc (Singapore branch) in respect of any matters in connection with the material.) RBS Securities Inc. is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 of Australia in respect of these financial services, and that RBS is regulated by the SEC under US laws, which differ from Australian laws. The views expressed in this publication accurately reflect the author’s personal views about the su bject financial instruments and issuers, and no part of the author’s compensation was, is, or will be directly or indirectly related to the specific rec ommendations or views contained herein.
7
