Mind the gap(s) as the Fed cuts rates

Global central banks are largely in a synchronous mood, which tends to heighten the correlation in longer tenor rates. But there are still some sizeable interest rate gaps between centres that could offer opportunities. When viewed through the prism of a United States reference, we think many of these gaps will have a tendency to narrow as the Federal Reserve delivers a significant easing in rates over the coming 12-18 months.

For example, the gap versus Japan is highly likely to tighten as the Bank of Japan goes the other way and hikes rates. And versus the eurozone, it's the excess of Federal Reserve cuts over European Central Bank cuts that is set to drive the narrowing. At the same time, some rate gaps will have a tendency to widen. Some central banks in emerging markets will have the capacity to cut by more than the Federal Reserve. A case in point is Banxico in Mexico, the judicial reform saga notwithstanding.

Here we examine a set of risk-free rates (or close proxies) akin to SOFR or ESTR, and we overlay with a cross currency type framework. The chart below shows spreads from 2yr to 10yr tenors, ordered from high to low (or negative).

The way to view the table above is to imagine yourself sitting in each of these centres, and then look at where US rates are in comparison. If you are sitting in Japan, you are looking up to higher US rates (positive spread), while from the standpoint of Mexico, you are looking down at US rates (negative spread).

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

Here we find for example that US rates are not just sitting well above the likes of Japanese or Chinese rates, but the respective spreads are also sitting above the historical averages. In contrast, while US rates are still well above eurozone rates, they are also moderately below the 5yr average spreads.

That said, we emphasise the point that many of these "positive" spreads are liable to ease lower in the coming months as the Federal Reserve executes on its rate-cutting ambitions. In consequence, and notwithstanding implied FX exposures, there is value today in positioning for most of these spreads to tighten, regardless of where they are today versus the average.

Cross-currency traders will also be looking for arbitrage opportunities, and this is often assessed by virtue of the size of the so-called cross-currency basis. Basically, this compensates for any anomalies between the vanilla fixed/float spreads (e.g. between 5yr SOFR and 5yr ESTR) and the projected 5yr FX forward rate. That implied 5yr EUR/USD FX forward rate has an implied spread, and any deviation between that and the vanilla spread is compensated with a basis. Market participants like to be on the right side of the basis as it is often then seen as an arbitrage.

What we are looking for here are deviations from zero on the basis, and the greater the deviation, the greater the perceived opportunity. See the table below. Large negative bases are viewed as presenting an opportunity to pay in these centres and paying in these centres means paying the local rate adjusted by the (negative) basis, which translates to paying a lower rate. In absolute terms, the bigger the negative basis the better for paying in these currencies. Most centres in the table exhibit a negative basis, which in turn is an echo of a premium being attached to the US dollar.

The trade then for these negative basis centres is to, for example, issue in USD and swap to say ESTR or TONA a.o., thereby receiving SOFR and paying, say, TONA adjusted for the (negative) basis. Whether this in fact results in a better outcome depends on the name in question. But that's the theory.