Eugene Leow, Rates Strategist

Philip Wee, FX Strategist

DBS Group Research

USD funding tightens in the basis swaps space

Tightness in USD funding showed up once again in short-term basis swaps (3M EUR and JPY). The magnitude of the move is sizable (25bps for 3M EUR/USD basis and 40bps for 3M USD/JPY basis). As USD funding tightens, FX-implied rates (such as the SGD SOR) tend to get impacted.

Tightness in USD funding appears to be concentrated in the short end and this coincided with the need for USD as we head into 2019. Notably, longer-term basis swaps (versus the USD) moved by much less, suggesting that this phenomenon would fade in the coming few months. Demand for short-term USD tends to be seasonal, peaking during the last quarter of the calendar year. Events played out similarly in 2015, 2016 and 2017 and this time should be no different.

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The more interesting aspect lies with how USD funding would be in 2019. In the early part of this year, markets participants raised USD in anticipation of tighter USD liquidity as the Fed continues to shrink its balance sheet. Unfortunately, the trade was overdone and led to excess USD liquidity showing up in the basis swaps. The pace of balance sheet reduction has accelerated to USD50bn/month and should theoretically mean that USD is becoming scarcer. However, this only forms part of the equation. The European Central Bank (ECB) is still poised to end asset purchases by the end of the year while the Bank of Japan has been stealth tapering. In relative terms, it becomes more difficult to gauge a currency’s scarcity when all three major central banks are withdrawing stimuli. At this point, with the 3M Libor marching higher once again, we are leaning towards USD funding getting marginally tighter, driving longer-term basis swaps (>1Y tenor) lower.

FX: USD to end 2018 on a firm note

The US dollar looks set to resume its appreciation in 4Q18. The Fed signaled, at its last FOMC meeting on September 26, its intention to increase interest rates a fourth time December. Markets have yet to fully discount a Fed Funds Rate ceiling of 2.50%. The implied yield for December Fed Funds Futures and the 3N Libor ended last Friday 2.25% and 2.40% respectively. The US 10Y bond yield is paying close attention to inflation pressures in America from higher import tariffs, two-month high oil prices, a tight labour market amidst stronger-than-expected growth. Close attention will be paid to wage growth in this Friday’s US monthly jobs report. A bond yield above May’s high of 3.13% would strengthen our case for the US Dollar Index (DXY) to push higher within a 95-100 range. The outlook for the other major currencies remain challenging. US President Trump will probably impose tariffs on the rest of China’s goods into the US ahead of the US mid-term elections on November 6. Brexit is a major uncertainty weighing on the British pound while Italy has everyone worried about the challenges pose by its budget to the single currency.

We remain negative on the euro which we see headed into a lower 1.10-1.15 range in 4Q18. European Central Bank (ECB) officials came out in force to reaffirm stable rates through summer 2019. This year’s outlook for the Eurozone economy, according to Bloomberg consensus, was downgraded again to 2.04% last Friday from 2.1% a week ago. The Italian 10Y bond yield surged to 3.15% from 2.89% last Friday after the new populist and far-right Italian government pushed for a wide budget deficit of 2.4% of GDP. While this was within the 3% limit set by the Maastricht criteria, it would not rein in the country’s large public debt, which at 131% of GDP, is already double the EU’s 60% limit. Italy will submit on October 15 its budget plans to the European Commission which will assess it before end-November. A confrontation between Rome and Brussels looks inevitable and coupled with more spikes in the Italian bond yield, would increase the risk of sovereign debt rating downgrades. Italy is currently rated two notches above junk by all three international rating agencies.

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