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From: Greg
Affiliation:
Address: greg.burke@ukonline.co.uk
Date: 09 Mar 2001
Time: 11:00:49
Briefly, there are two main reasons for the basis level:
i) technical; and ii) supply and demand for issuance.
i)Technical reason. Using as an example the 10yr Usd/Jpy basis swap which is now trading at Jpy 3m Libor -18 against Usd 3m Libor flat. LIBOR is an approximate average of offer rates from different banks. Currently 7 out of 16 contributing banks are Japanese domestic. They have Japan premium factored into their cost of funding. The average fix will be inflated due to 50% of the panel pricing in this premium. So, top quality European/US banks can borrow at rates less than the fixing on Libor. The basis swap reflects this. Jpy Tibor is even more pronounced, given the fact that the entire panel is Japanese banks. However, if you look at the Libor panel there doesnst seem to be enough of a difference to justify 18 basis points running in 10yrs. The reason for this is the BOJ's current policy of injecting liquidity into the short-end of the market. This brings Japanese short term funding closer to international bank levels and, correspondingly, creates shape in the basis curve (e.g. 1yr basis level is approximately flat). The basis curve, to some extent, prices in the fact that this provision of liquidity is not going to be sustained in the long-term.
ii) Supply and Demand for issuance. Using as an example, the build up of investor demand for EUR bond paper up until October 1998. Convergence strategies by US investors created significant demand for medium to long-dated ESP and ITL bonds. Fixed US paper was not the flavour of the day, because at that time the Fed was ever-poised to respond to inflationary pressures of the booming US economy. Banks' basis swap positions built up and were generally warehoused. The crunch came in October 98, when the coalescence of 11 currencies into one Eur currency created a massive short basis swap position in the market. The DEM/USD 5yr level, which had stayed at +2 for the previous 10yrs, quickly dropped to -12 as every bank on the street tried to receive the basis - supply and demand.
Picking the next currency, the bonds of which are in high demand by investors, is the only way to predict moves in the basis market.
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