CME paper: Is US vs Euro rate differential greater than central bank rates?

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Erik Norland, senior economist, CME Group.

A research paper by Erik Norland, senior economist of CME Group, has found that the difference between the futures and the spot price for the Euro / US dollar (EURUSD) exchange rate on the CME is around 60-100 basis points (bps). The difference based on Fed policy rates of between zero and 25bps and the European Central Bank (ECB) policy at -50bps, should be an interest rate differential between USD and EUR of 50-75bps, according to Norland.

Norland observed, “One million Euribor on Friday was at 0.03% whereas I million US Libor was at 0.15% – a difference of 0.12%. That’s quite far from the 70-80bps seen in the FX Swap Rate Monitor.”

CME’s data, which is taken from its FX Swap Rate Monitor, based on the CME FX Futures and FX Link markets, and the difference from cash rates has implications for traders using FX swaps.

A trader can buy Euro and EUR/USD futures simultaneously to lock the FX swap rate of 70-80 bps then invest euro in the European market, where the return is 3 bps based on Euribor, and after a month could reverse the futures trade while simultaneously switching euros to dollars in order to capture the larger basis point return than the 15 bps that US Libor offers.

Norland notes in his paper that policy rates between the two central banks are far apart, observing that in February and March, the Fed cut rates from the 1.75-2.00% range to 0-0.25% while the the ECB last cut rates on September 12, 2019, going from -40 to -50 basis points in contrast and opted not to cut rates further into negative territory amid lockdowns in the first half of 2020.

“Expectations were that negative rates would weaken EUR: after all, who would want to pay to deposit EUR with the ECB? That said, as we have often seen in Europe and elsewhere, negative rates did not prevent the currency from strengthening,” he wrote. “EUR weakened on a trade-weighted basis after the ECB’s first cuts into negative territory in 2014 and 2015. Following subsequent reductions to -30, -40 and -50bps, EUR strengthened each time. It may be that by taxing the banking system through negative deposit rates, the ECB is actually contracting rather than expanding money supply, leading investors to hoard cash.”

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