Cross Currency Basis Spreads answers how much is the cost to swap 2 currencies, what is the currency supply and demand relationship, currency balance Vs imbalance, high vs low spreads to determine money market Risk Vs health as in risks, liquidity to ability to price of bonds yields as well as bond supplies.
Cross Currency Basis Spreads takes Interest Rate Swaps to the next lowest analytical depths because the spreads are unsecured interest rates and float at different rates daily, weekly, monthly. Interest Rate Swaps are quite different because those transactions are secured interest rates by agreement between 2 parties. Interest rate Swaps though vital impart zero information to a currency trade nor to a Forward exchange rate, especially today’s QE distorted and mispriced interest rate markets.
An Interest Rate Swap informs the 2 various Swap rates but then comes the Cross Currency Basis Spread questions as in what is the currency cost to each leg in the transaction, what is the spread and residuals against the spreads. Because Europe and America was designed as complete opposite financial systems so not to form a collusion, Cross Currency Basis Spreads as well as Interest Rate Swaps in EUR/USD will always, for the most part, factor a negative and positive.
The main difference between an Interest Rate Swap and Cross Currency Basis Spreads is an Interest Rate Swap involves factor to a bond yield while Cross Currency Basis Spreads are pure unsecured interest rate driven. Many traders focus on bond yields but its not the manner alone to view currency markets and prices because its a comparison between 2 unrelated markets. An Interest Rate Swap informs zero information to Cross Currency Basis Spread narrow and wide nor overall money market risks but both inform money outflows and inflows across borders as money must earn profit.
Smartest FX and / or Interest rate traders employ Forward Points because the numbers in my opinion are far easier to view and factor to a currency price, spreads and interest rates as well as to factor cash flows to transactions. Many offer Forward Points on an overall scale to imply exchange rate factors but this isn’t the way to view a currency price because it lacks the Forward Price and bond yield relationship.
Forward exchange rates are sold rather than bought. A 2 year Forward Exchange Rate price for example is seen at the 2 year yield. The range of the 2 year yield is transformed from yields to Forward Points to offer the price of the exchange rate to sell the Forward exchange rate. Same deal is performed with interest rates.
The Forward Exchange rate example is to apply to today’s trade is EUR/USD 1.1808. For many weeks, 1.1808 was the premiere short term Forward Price and it held for the longest time. Short term for my personal view is right round the 100 day average as this is the point where a vast majority of Forward traders were selling EUR/USD.
Many topics here deserve far more in depth explanations and methodologies. The overall point is currency markets are well defined and self contained markets because currencies and prices are backed by hundreds of years of market factors and conventions. If currencies are here 100 years from now then the same market conventions will remain.
The challenge to traders is not to necessarily master Cross Currency Basis Spreads nor Interest Rate Swaps but to have decent understanding to market conventions then abilities exist to design a workable trading system to last for the ages. Most vital overall to Cross Currency Basis Spreads is current wides because it informs to risks in money markets.
Personally, I deigned my own trading systems based on deep reads into academic and central bank papers. Don’t ever mimic these guys because they aren’t traders and as researchers they won’t alone bring riches but know what they are doing so to take their way to a better trade level.
All presented information was deeply outlined by examples in Inside the Currency Market 6 years ago.
EUR/USD, today’s 1.1806 broke higher so now view 1.1822 as next point for today then 1.1851. Downside must now break 1.1807 as 1.1806 rose 1 pip. Further support is located at 1.1764.
EUR/JPY. Breaks for today above are located at 133.07 and 133.33. Below 133.07 then comes 133.01.
USD/JPY. Break Points overall 112.43 and 112.18. Above break point is 112.69.
NZD/USD break points 0.7006 and 0.7043.