Eoin Treacy's view -
In both cases, those shifting money across borders want to avoid foreign exchange risk, so they hedge using basis swaps. These involve swapping yen or euros in exchange for dollars, which will be swapped back at the end of the contract at the forward rate, typically a year or more later. Meanwhile they pay each other interest at the Libor rate for their currency, plus (or minus) the basis, which moves with demand.
Without banks willing to take the other side of the trade, the basis has blown out to levels usually only seen when the financial system is in meltdown, as in 2008-9 after Lehman or in 2011-2 as the euro seemed to be failing.
Most investors care as much about basis swaps as they do about cash-settled butter futures, but the shifts in the basis have already had highly visible effects. U.S. companies now have little reason to issue bonds in euros, because the basis cost has risen so much it almost entirely offsets the benefit of issuing at a lower yield in Europe. Japanese investors have no reason to buy U.S. Treasurys, as the extra yield they earn would all be eaten up by the basis when they hedge.
In short, the world’s banks aren't doing what they should be doing to grease the flows of money between countries. They’re too regulated and too scared of the risks, slight as those are.
We should welcome the fact that banks now try to price such risks, rather than the precrisis practice of simply ignoring them, but perhaps they are going too far the other way.
The reorientation of the money markets funds sector due to take place on October 14th has been a contributing factor in the uptick in LIBOR rates seen over the last couple of months. As the above article highlights it is not the only factor.
Cross Currency Basis Swaps represent one of the most expedient ways of hedging currency exposure to interest rates and therefore are a hedged carry trade. LIBOR rates breaking out may be considered one of the unintended consequences of negative interest rates.
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