Euro-Dollar Being Driven by Inefficiencies in the Forwards Market and Over-Regulation is to Blame

The Euro-to-Dollar exchange rate could be pressured lower due to inefficiencies in the foreign exchange forward contract market argues an analysts at a leading German bank.

Inefficiences in global foreign exchange markets could be one reason why the Euro will lower against the Dollar over the remainder of 2017. 

It has been shown by an Ulrich Leuchtmann at Commerzbank that interest rate arbitrage profit is consistently available for the taking on longer-term currency deals, which for EUR/USD translates into a risk free advantage in holding Dollars.

How the Market Works

Currency deals are subject to 'carry', which is the profit (or loss) available due to the difference between the interest rates on offer in the two different currency jurisdictions involved in the exchange.

Normally investors will seek to borrow in low interest currency such as the Yen and park the money in higher interest currencies such as the Australian Dollar thus making a profit on the difference - however, sometimes in commercial transactions there is no profit motive as the deal has to be done out of necessity.

Forward contracts are often used in these deals to eradicate the risk of the exchange rate shifting radically in the future when the money is repatriated, and they do this by locking in an exchange rate in the future - known as the forward rate.

When markets are working efficiently the forward rate is such that it discounts the arbitrage profit potential from the interest rate differential; this phenomena is known as Covered Interest Parity, or CIP.

Market Inefficiencies

Commerzbank's Leuchtman has discovered that markets are not working efficiently, as the forward contract rates are not discounting all the profit from carry, or the interest rate arbitrage, and a risk-free profit remains on the table for the taking.

Normally this loophole would represent a veritable 'treasure trove' for professional traders and would be quickly exploited by hedge funds and large banks as it offers a risk free profitable trading opportunity, however, for some reason this does not appear to be the case.

"The FX forward market is no longer efficient. Obviously there are not sufficient numbers of market participants who could carry out CIP arbitrage to a sufficient extent to re-establish CIP. At least as far as banks are concerned the reasons behind that are easy to determine: banking regulations and monetary policy," says Leuchtmann.

The inefficient drift in the forward rate, he says, is due to over-regulation of banks which means they are not now able to leverage to the same degree as before, because according to Basel III they need to have higher capital requirements.

These regulations were imposed because of the financial risks associated with the financial crisis when banks were overleveraged, and had to be bailed out in the end.

A Risk-Free Play?

Leuchtmann first discovered the drift in forward rates on Bloomberg when looking at EUR/USD forwards.

After making some calculations he discovered that a bank borrowing in the US and exchanging a million Dollars into Euros, parking the money for three months, earning (lower) Eurozone interest, and then repatriating the money at the locked-in forward contract rate quoted on Bloomberg, would make $1,362 more than if it had simply leant the money at LIBOR on the interbank market.

The $1,362 represents an essentially risk-free profit due to the inefficient forward contract rate.

In this example - the forward rate, at 1.67396, is actually too high. 

Leuchtmann calls the drift away from the efficient forward rate 'basis'.

Basis is calculated as the number of basis points away from the zero rate, which is the efficient rate. 

The analyst notes how far basis has drifted down since the financial crisis in the chart below:

Bearish impact on EUR/USD

Leuchtmann argues there are increasing signs that the inefficient forward rates are having an impact on spot rates.

In the example above the inefficient forward rate benefited the investor holding Euros, however, there is even more risk free arbitrage profit available to the investor trading in the opposite direction and holding Dollars - which means being short EUR/USD.

"There is increasing evidence that this distortion of the forward market is also having an effect of the spot market. The explanation is simple: Due to a falling EUR-USD basis the carry
advantage of EUR-USD shorts is increasing," says the Commerzbank analyst.

The chart below shows how the fall in 'basis' pre-empted the recent pull-back in the Euro by several days.

"I know that from here on money market analysts are going to think I am mad. They tell the story the other way round. For them the spot price is responsible for the development of the basis. However, evidence is supporting my point of view. This time round the 3M basis clearly started falling before EUR-USD turned south over the past few days," he adds.

As far as 'conventional' currency drivers go, Leuchtmann dismisses Macron's Euro-positive speech on deeper Eurozone integration as lacking concrete proposals for "integration".

He further suggests gains were offset by the Presidents reference to a transaction tax which raised concerns about French "dirigisme".

Yellen on the other hand boosted the Dollar by reasserting the hawkish tenor of the FOMC, and making ever more likely a December rate hike.

Yet Leuchtmann notes, interestingly too that when the Fed has been wrong in recent years it has always been due to being prematurely hawkish, inferring that the longer-term Fed projections may be subject to revision.

QE Effect

The distortions in the forward market have also been exacerbated by the heavy QE practiced by the European Central Bank (ECB) and the Bank of Japan (BOJ).

"These days European and Japanese banks in particular have to hold (expensive) liquidity surpluses, enforced on them as a result of the ECB’s and BOJ’s QE policies," says Leuchtmann.

He goes onto explain in detail how it is liquidity which is the constraint now.

"Since it is no longer liquidity, but equity that constitutes the restricting factor for banking activities, the FX market can clearly no longer balance liquidity supply and demand in different currencies. As FX swap positions bind equity under Basel III (3%, or even 6% for systemically relevant US banks) banks have become restricted in their ability to carry out CIP arbitrage," says the analyst.