GLOBAL INTEREST RATES: DISLOCATIONS AND OPPORTUNITIES Francesco Tonin, Bloomberg MAY // 2 // 2017
JAPANIFICATION OF TREASURIES 2 Dislocations in the relation between US rates and Japanese rates has eliminated the appeal for Japanese investors willing to purchase US debt and synthetically turn it into Japanese cash flows
TO A US INVESTOR, JAPANESE T-BILLS YIELD MORE THAN US T-BILLS 3 A US investor can purchase Japanese T-Bills and swap all the cash flows into dollar cash flows, thus achieving a yield of 1.22% which is higher than US T- Bills
TO A EUR INVESTOR, ANY YIELD PICK UP IS BETTER THAN NOTHING 4 Euro investors starved for yield have turned to USD debt but of recent the yield pick up has dwindled to zero
THE NEVER ENDING UST RALLY 5 A lack of demand by foreign buyers could sap demand for US treasury bonds and create headwinds for the secular bullish UST trend.
THE NEVER ENDING UST RALLY 6 Here we show the impact of the Trump trade.
THE VIEW FROM ASSET MANAGERS It s been a no-brainer since forever, said Sekiai, a money manager at Tokyo-based DIAM Co., which oversees about $166 billion. People like a simple narrative, said Jeffrey Rosenberg, the chief investment strategist for fixed income at BlackRock Inc., which oversees $4.6 trillion. But there isn t a free lunch. You can t simply talk about yield differentials without talking about currency differentials. Treasuries will remain a better alternative for many overseas investors as long as an advantage exists, no matter how small the hedged yield pickup has become, according to Ralph Axel, a bond analyst at Bank of America Corp.: They ll just keep buying. Because of forces like negative rates and quantitative easing outside the U.S., you clearly have a long-lasting bid. We re at a point now where investors have to start thinking about this, said Sachin Gupta, a foreign-bond fund manager at Pimco, which oversees $1.51 trillion. As the cost of hedging rises to such an extent, there s no extra carry to be had. That itself will slow down the demand -- and, at some point, even reverse the demand -- for Treasuries. 7
ORIGINS OF THE DISLOCATION 8 The cross currency basis is responsible for the black magic involved in those arbitrage trades
DEFINITION OF THE CROSS CURRENCY BASIS 9 The definition of the basis is based on a floating-floating cross currency swap. 3M EURIBOR BANK Corporation or Asset Manager 3M USD LIBOR + Basis
NUMERICAL DETAILS ABOUT THE BASIS 10 In this example, EURIBOR flat for 5 years can be exchanged for USD Libor plus 46 basis points
UNDERLYING CROSS CURRENCY FLOAT-TO-FLOAT SWAP We show here the details of the underlying cross currency float-to-float swap that defines the notion of the basis. Notice that the swap is floating in both legs, so it needs to be overlaid with a domestic fix-to-floating interest rate swap in most practical applications. This makes the meaning of the sign in the basis counterintuitive 11
UNDERLYING CROSS CURRENCY FLOAT-TO-FLOAT SWAP These are the cash flows of the five year swap, shown in USD and in EUR. The forward rate is used to translate from one currency to another. We notice that there is a balloon payment at the end, and the ratio between the USD balloon payment and the euro balloon payment equals the spot rate at trade date. 12 Last date balloon payment exchanged at the spot rate
MEASURES OF STRESS IN THE FINANCIAL SECTOR 13 The LIBOR-OIS spread, or LOIS, is a measure of fragility in the banking sector
THE HISTORICAL ORIGIN OF THE DILEMMA 14 We can easily see how historically the risk of the banking sector was underpriced before the collapse of Lehman Brothers in 2008
MAIN CHART THAT TELLS THE WHOLE STORY 15 Here is the chart of the EURUSD 1y (EURBS1 Curncy) and USDJPY 1y (JYBS1 Curncy) cross currency basis. Note the basis is a negative number.
PRACTICAL IMPLICATION OF THE BASIS 16 To prove our point with an example, let us look at the Covered Interest Rate Parity (CIP) for EURUSD. In this case we calculate the forward points using the USD and EUR interest rates and we discover, in the one-year tenor, an arbitrage of 91 pips.
FORENSIC RESEARCH ON THE ARBITRAGE 17 We have a look at the EUR interest rate curve used for the calculation of the forward points: the standard EUR curve used by default in EUR interest rate swaps
DISSECTING THE ARBITRAGE 18 We change the curve to EUR vs. USD Basis curve, which takes the cross currency basis into account
CHECKING THE ARBITRAGE 19 And now the discrepancy is just 36 pips.
HOW TO UNDERSTAND FX EXPOSURES USING SILLY LITTLE DRAWINGS 20 After changing the curve to the Basis curve, the arbitrage is reduced to 35 pips.
CROSS CURRENCY BASIS COMPARISON BY COUNTRY 21 We can compare which currencies exhibit the largest level of the basis. Why does Australia have a positive basis?
EXPLANATION OF THE BASIS VIA CREDIT ARBITRAGE 22 Corporations will tend to borrow in those currencies whose markets offer the most favorable conditions: in this chart we show the EURUSD basis together with the spread between US corporate spreads and Euro corporate spreads. As the difference increase, US corporates tend to borrow in euros and then need to swap the debt to synthetic USD debt and this increases the basis. Note that this phenomenon has been specific to Europe, due to the uniqueness of the ECB program
EXPLANATION OF WHY CORP SPREAD^2 CREATES THE BASIS 23 Bond Investors Coupons on EUR Bond Issued EUR Fixed BANK 1 BANK 2 3M EURIBOR 3M EURIBOR US Corporation 3M USD LIBOR + Basis 3M USD LIBOR BANK 3 USD Fixed
REVERSE YANKEE BONDS The ECB bond purchase program drove EUR-denominated corporate bond spreads lower than they US counterparts In response, US corporates have found more cost-effective to issue in euros, and then swap the proceeds back into USD This corresponded to a surge of issuance in euro-denominated corporate bonds since 2014 24
EXPLANATION OF WHY EURO ASSET MANAGERS CONTRIBUTE TO THE BASIS 25 US Bond Coupons on USD Bond Purchased USD Fixed BANK 1 BANK 2 3M USD LIBOR 3M USD LIBOR + Basis European Asset Manager 3M EURIBOR 3M EURIBOR BANK 3 EUR Fixed
EXPLANATION OF WHY EUROPEAN BANKS CONTRIBUTE TO THE BASIS 26 US Loan Coupons on USD Loan USD Fixed BANK 1 3M USD LIBOR BANK 2 3M USD LIBOR + Basis 3M Yen LIBOR Japanese Bank 3M Yen LIBOR BANK 3 JPY Fixed JPY Depositors JPY Interest on Deposits
PLACEHOLDER 27 Charts of issuance of EUR-denominated corporate bonds over time
THE CARRY TRADE CONTRIBUTES TO EXPLAIN THE BASIS 28 USD Investment Coupons on USD Bond Purchased USD Fixed BANK 1 3M USD LIBOR BANK 2 3M USD LIBOR + Basis 3M Yen LIBOR Carry Trade Player 3M Yen LIBOR BANK 3 Yen Fixed JPY Liability Yen Interest on Borrowed Money
WHERE ARE THE ARBITRAGEURS? Hedge funds, CTA s and all sorts of investors should be able to take advantage of the cross currency basis and should be able to make it disappear But time goes by and the financial crisis recedes more and more in the past and the basis does not show signs of closing This is due to the very reason the basis came to be in the first place: the great financial crisis In order to arbitrage the basis, people have to be able to rent balance sheet from their bank counterparties, the very activity that recent legislation has made so expensive Credit charges, more discriminating Prime Brokerages, margin requirements all conjure to keep the basis alive 29
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