Consider the gap(s) as the Fed cuts rates

By Padhraic Garvey, CFA

Global central banks are largely in a synchronous mood, which tends to intensify the correlation in longer rates. But there are still some sizable interest rate differences between centers that could offer opportunities. When viewed through from a US benchmark, we believe many of these gaps will tend to narrow as the Federal Reserve provides significant rate easing over the next 12-18 months.

For example, the spread against Japan is very likely to narrow as the Bank of Japan reverses and raises rates. And vis-à-vis the Eurozone, the excess of cuts by the Federal Reserve compared to cuts by the European Central Bank is what will determine the tightening. At the same time, some rate differentials will tend to widen. Some central banks in emerging markets will have the capacity to cut by more than the Federal Reserve. An example of this is Banxico in Mexico, despite the judicial reform saga.

Here we examine a set of risk-free rates (or close proxies) similar to SOFR or ESTR and overlay it with a cross-value framework. The chart below shows the 2-year to 10-year spreads, ordered from highest to lowest (or negative).

Selected spreads in the United States – a lot of loopholes to negotiate

Basis Points (bps)

The way to visualize the table above is to imagine sitting in each of these centers and then see where the US fares compare. If you’re in Japan, you’re looking at higher US rates (positive spread), while from Mexico’s point of view, you’re looking at lower US rates (negative spread).

Here’s the scary blue technical part

If you have USD debt and want to lower your interest rate costs, look for positive spreads. And the higher the better. If you have non-USD assets, for example those denominated in Euros, proceed in the same way. In both cases, SOFR is received and ESTR (or any other low rate center) is paid, for a positive spread (aka positive carry).

If you are in the Eurozone, then you look at the spreads above the Eurozone row to identify positive carry opportunities where ESTR is received. If ESTR is paid, then the lines below are for the positive carriage. If you are based in Japan, then there are only positive shipping opportunities achieved when TONA is paid. And if it is in Mexico, there are only negative shipping possibilities, that is, if MXN is paid.

And why would anyone do a negative shipping exchange in currency? Two reasons. First, one could adapt to the circumstances, for example issuing a bond in USD and exchanging in MXN for convenience. Or two, if from a trading perspective, there is a belief that the low-yielding center currency will appreciate more than the currency forwards predict. As here, assuming MXN debt (vs. SOFR) means praying for MXN weakness (vs. USD), and the FX forward curve is the breakeven line.

Phew, okay, let’s continue. While the above table is useful for eyeball spreads, it is relevant to ask whether the spreads we are seeing are high or low relative to history. This is answered in the table below. Here we show how current spreads compare to average spreads (5 years) for each tenor. A positive spread means it is above average, where Sweden comes out on top. A negative spread means that current spreads are below their historical average. So, for example, spreads in Taiwan are wide in absolute terms, but happen to be below average by about 50-60 bp.

Here we find, for example, that US rates are not only well above Japanese or Chinese rates, but their respective spreads are above historical averages. Conversely, while US rates are still well above Eurozone rates, they are also moderately below 5-year average spreads.

That said, we stress that many of these “positive” spreads are likely to decline in the coming months as the Federal Reserve executes on its rate-cutting ambitions. Consequently, and despite implied currency exposures, today it is useful to position for most of these spreads to tighten, regardless of where they stand today relative to the average.

Selected spreads in the United States – relative to 5-year averages

Basis Points (bps)

If you made it this far, you made it here! So we won’t have to hide what’s coming with a scary blue technical decline.

Cross-currency traders will also look for arbitrage opportunities, and this is often assessed by virtue of the size of the so-called cross-currency basis. Basically, this offsets any anomaly between vanilla fixed/float spreads (eg between 5-year SOFR and 5-year ESTR) and the projected 5-year FX exchange rate. The implied 5-year EUR/USD FX forward rate has an implied spread and any deviation between this and the vanilla spread is offset by a basis. Market participants like to be on the right side of the base, as it often is, then seen as an arbitrage.

What we’re looking for here are the deviations from zero on the basis, and the greater the deviation, the greater the perceived opportunity. See the table below. Large negative bases are seen as presenting an opportunity to pay in these centers, and paying in these centers means paying the base-adjusted (negative) local rate, which translates into paying a lower rate. In absolute terms, the larger the negative base, the better it is for payment in these currencies. Most of the centers in the table show a negative base, which in turn is an echo of a premium attached to the US dollar.

The trade for these negative basis centers is for example to issue in USD and change to say ESTR or TONA, therefore receiving SOFR and paying for example TONA adjusted for the (negative) basis. Whether this actually leads to a better result depends on the name in question. But that’s the theory.

Selected Cross Basis Spreads to the United States – Arbitrage Opportunity

Basis Points (bps)

So where does that leave us? Lots of spreads between centers and potential for convergence that could present opportunities, with underlying arbitrages currently increasing most spreads. And a rate-cutting ambition from the Federal Reserve, which is likely to cut both over the next 12-18 months. Taking advantage now could turn the convergence process into one that could bring benefits, in our view.

Content Disclaimer

This publication has been prepared by ING for informational purposes only, regardless of the means, financial situation or investment objectives of a particular user. The information does not constitute an investment recommendation, nor does it constitute investment, legal or tax advice or an offer or solicitation to buy or sell any financial instrument. Read more

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