• Receive 1Y 1Y EUR/USD cross currency basis.
• Open ½ position at -5.5bp with the possibility of another ½ position at 0.
• Levels: target at -30bp, stop at 10bp, roll down flat in the first three months.
Repricing of the EUR/USD basis when ECB delivers
The ongoing tightening of the liquidity situation in the EUR money market since the repayment of the 2011/2012 LTROs has pushed the short-end rates and fixings higher. This has also effected the EUR/USD cross currency basis (hereafter the EUR/USD basis), which has been pushed to almost pre-crisis tight levels. As the relative liquidity of USD and EUR is tradable in this instrument, relative EUR scarcity and USD abundance has been the main driver of the past year’s tightening (see chart).
Going forward, we believe this issue will reverse as the ECB and the Fed are on a divergent path on liquidity issues: the ECB is set to ease again at the June meeting (see ECB research #3: ECB will surprise the markets, 26 May 2014) and the Fed will most likely end its asset purchases in Q4 this year.
If our expectation of an introduction of a new LTRO is realised, we expect strong demand and thereby a significant liquidity injection lasting for several years in the EUR system. As seen below, there is an historically strong relationship between the ‘liquidity component’ of EUR/USD basis (EONIA/OIS basis) and eurozone excess liquidity, which indicates a large downside to EUR/USD basis if the ECB acts.
In our view, negative deposit rates will be also work as a catalyst for this push because of the ‘hot potato effect’ created by the negative deposit rate, as the experiences from Denmark and Switzerland show.
We prefer the 1Y 1Y segment as it fits well with ECB liquidity measures being semi-permanent/long term without moving too far out along the curve, where the flows of cross-border swapped bond issues are dominant.
To Read the Entire Report Please Click on the pdf File Below