Refusing free money is telltale sign of fear

Fear is when you want to pick up the shiny nickel lying in the road, but freeze at the sound of the approaching steamroller. The currency market equivalent of this is a widening basis swap — free money that banks are too scared to pocket. For the fourth time in the past decade, the fear gauge is starting to go wild.
Don’t ignore the warning, particularly in South Korea, a reliable indicator of trouble in the past. What’s happening in an esoteric corner of currency markets will also shape banking trends.
When two parties swap currencies for, say, five years, every three or six months each earns interest in the currency it bought, and pays interest in the currency it sold. The dollar is usually involved: Someone, somewhere always wants the greenback to oil the wheels of commerce. It shouldn’t cost too much more to obtain dollars this way than to borrow them in the London interbank market. If it did, global banks would jump right in to arbitrage away the difference and make risk-free money in the process.
That used to be true before the 2008 crisis. Since the advent of the Dodd-Frank legislation and the Volcker rule, however, Wall Street banks’ risk appetite has dwindled, and a gaping basis swap spread — a numerical measure of badly wanting dollar funding and not getting it — has become a reliable indicator of nervousness around the world. One such squeeze is currently on.
You see it in South Korea, where the roundabout way of raising dollar funding that I just described cost as much as 3% for three months last week, a hefty 2-percentage-point premium over the three-month Libor. That’s a lot of nickels begging to be picked up by global banks. But the crumbling of their own share prices
amid the economic dislocation caused by the coronavirus is making lenders hesitant to expand their balance sheets. Might as well save capital for
a share buyback.
The G-10 average of basis swap spreads, a favourite gauge of fear for researchers at the Bank for International Settlements, suggests the tightness in the dollar market has risen with the trade-weighted US currency. But the aggregate picture, while deteriorating, isn’t as bad yet as during the financial crisis. The G-10 basis swap spread is less than half as wide as it was in 2009, the euro zone troubles of 2011 or the 2016 dislocation after China’s sudden devaluation of the yuan.
The Korean won-dollar spread, however, is off the charts. It’s worrying, because South Korea has acted as a canary in the coal mine before. In 2007, Korean basis swaps started acting up in June — 15 months before the collapse of Lehman Brothers.

—Bloomberg

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services. He previously was
a columnist for Reuters Breakingviews.
He has also worked for the Straits Times, ET NOW and Bloomberg News