Revisiting the Comovement of Cross-Currency Basis and the Dollar: A Rolling Correlation Approach

Abstract

In recent years, the idea of a robust negative association between changes in the cross-currency basis and the dollar has become a well-known theme in the finance literature. In this piece, the authors revisit this topic from a purely empirical, data-driven perspective, taking a deeper look at rolling, rather than static, correlations at different windows and using the dollar bases of G10 and 10 emerging market (EM) currencies. Overall, results obtained do not support a persistent negative relationship between changes in the basis and the dollar, especially using short rolling windows. At the same time, as evidenced by the negative correlations in some historical episodes, a negative comovement between changes in the basis and the dollar cannot be ruled out, particularly at longer rolling windows. Hence the nature of the relationship appears to be dynamic, varying from negative to positive and vice-versa. As such, the evidence that the basis–dollar relationship is robustly negative appears to be window-dependent and may not always be tenable. As with nearly everything else in the financial markets, the relationship between changes in the basis and the dollar is anything but static. This result has implications for trade positioning in the cross-currency basis swap markets.

TOPICS: Currency, emerging market, interest-rate and currency swaps

Key Findings

• • Using dynamic correlations, we document no support for a consistently negative dynamic relation between changes in the cross-currency basis swap spreads and the dollar, even in the post-crisis era, especially at short rolling windows.

• • Instead, the dynamic relation seems to vary in direction, from negative to positive or vice-versa. Thus, like nearly everything else in the financial markets, the direction of comovement between changes in the basis and the dollar is not static.

• • This result has broader implications for optimal and profitable positioning in the cross-currency basis swap markets in the current world of low rates, narrower FX trading range on the back of depressed vol, and persistent covered interest parity deviations.