A question of yield

Macro Man needs to keep it kind of short today as he is in the process of migrating to a new computer and he needs to work on "the build" ce soir.  It's just as well, as yesterday's markets were fairly dull, albeit with a few notable twists.  Although the euro closed largely unchanged on the day, for example, it still managed to hit its lowest level since April...and this with US fixed income putting in an all-too-rare-of-late rally to boot!

Of course, not all fixed income rallies are created equal, particularly when it pertains to currencies.   After all, the interest rates paid and received by FX punters via the FX swap market sometimes bear only a passing resemblance to yields displayed in other markets.   Such is the case at the moment, where the difference between yields in the FX swap market and those in the (fictional) interbank lending market, i.e. basis swaps, are widening sharply.

We've seen this film before, of course; during both the GFC and the European sovereign crisis, EUR/USD basis swaps blew out, indicating a sharp rise in USD borrowing costs for those wishing to lend euros.   This was largely a function of the need for dollars and the creditworthiness of Eurozone banks at the time.

Fast forward to today, and we are once again seeing basis swaps widen....and not just in euros.  Basis swaps in other currencies are also widening sharply, indicating a rise in USD funding costs well above those implied by looking at a list of LIBOR rates.  The chart below illustrates the fall in 3 month basis swaps for the euro, yen, and sterling.  (Note that in basis swaps it is assumed that dollar rates are a given, so they are quoted in terms of yield differential for the non-USD currency.  A negative price indicates a lower relative yield for the non-$ currency; in practice, this actually represents a higher yield for USD.)

Why is this happening?  Obviously in the case of 3 month, the turn over the new year plays a part, as banks tend to hoard liquidity over the period.   That having been said, basis swaps have widened throughout the entire curve, even as far as 10 years, so there is clearly something else going on.   Concerns over Fed tightening probably also play a part; there is less appetite to lend dollars if the perception is that yields are going to rise.  One used to see that in LIBOR in the run up to Fed rate hikes, but obviously LIBOR is a fiction these days (though one that has the imprimatur of the authorities, so that's OK!)  Most importantly, and probably inevitably, the brave new world of regulation is having an impact via balance sheet charges and other disincentives to provide liquidity.

The upshot is that the effective yield that one earns from owning dollars via FX forwards is rising quite nicely...providing an extra kicker for greenback beyond that of the relative policy deltas of the Fed and ECB.

More vanilla yields also appear to be strongly tilted in favour of the dollar.   The 5 year government bond spread between the US and Germany is quite close to all time highs since German unification.  It's quite striking, actually; the spread has never been anything close to this wide with money market yields at current levels.   Then again, the last time Germany had a legitimately dovish central banker in charge of monetary policy was probably during the Weimar Republic; certainly the prior history of the chart doesn't include any QE bond-buying!

As an aside, the contemporary correlation of EUR/USD to these yield spreads isn't actually that great.   Going back to 1990, the correlation with the 5 year spread is -0.29, and the correlation with the 3m spread is just -0.2.   That having been said, with yields so low and the relative delta of monetary policy shifting in favor of the US for the first time in many people's careers, it is unsurprising that these shifts are having an outsized impact.

Nevertheless, it is worth asking whether European yields have already compressed too far.  The 2y2y swap yield, which presumably post-dates the ECB's QE program, is priced at just 30 bps.  That's lower than the lowest spot 2y swap rate in the US during the entire QE/ZIRP/forward guidance fandango.  OK, you say, but the ECB depo rate is negative and a-fixin' to get more so.

Fine.  Central bank deposit rates rates are already more negative in Sweden and Denmark (which pegs to the euro and has had to run a super-dovish monetary policy to avoid undue upward currency  pressure.)   If we look at a chart of 2y2y yields in each of these currencies, the euro is notable for the paucity of its yield.

In fairness, euro 2y2y rates have been lower than the Scandis throughout the past several years, despite those currencies having lower interest rates, etc.  As such, pointing at the low euro yield in comparison with theirs isn't exactly a compelling reason to pay Europe.

That being said, it is notable that SEK 2y2y yields have not approached their spring lows despite an increase in Riksbank QE.  Macro Man would not be surprised to see a similar dynamic play out in Europe.   It might be a little premature, but paying something like 2y2y Europe is going to look awfully attractive sometime soon, both as an outright trade and as a hedge against short euro positions.   For the time being, Macro Man will watch and wait....and hope the yields grind even lower.

Damn, looks like most of the new computer build will have to wait til tomorrow...