The widening of the cross-currency basis (JPY, EUR and GBP, in particular) against the US dollar provides further evidence of a structural dollar-funding shortage, which is set to worsen as the Fed tightens. Although the spread typically widens towards year end, the violent surge at the end of September suggests that stresses are mounting in the dollar funding markets. Even if the basis narrows again we would warn that the stresses in dollar funding markets have not gone away, and further sharp re-widenings in the basis are a likelihood.

The combined impact of US quantitative tightening, demand for currency hedges and a deterioration in credit risk is likely to keep pressure on the basis. In the case of the latter, we have previously noted the increase in global credit default swap spreads and can add the deterioration in bank equity performance, which suggests dollar lenders may exact a higher risk premium for providing liquidity. It is also worth stressing that due to tighter regulation and higher liquidity requirements, the capacity of banks to warehouse cross-currency risk has been significantly reduced. As such, large international banks are far less able to arbitrage away the basis, leading to sharp moves we witnessed in September, as well as last December.

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Source: Bloomberg, Macrobond and Variant Perception