European Central Bank working paper finds wider USD-EUR cross-currency basis drives euro-area shifts out of USD bonds and moves bond yields

The European Central Bank has published Working Paper 3017 on how deviations from covered interest rate parity, measured by the USD-EUR cross-currency basis, affect international capital flows. Using euro-area regulatory data on FX derivatives and securities holdings, the paper finds that when the basis widens and currency hedging becomes more expensive, euro-area investors reduce hedging activity and cut USD bond holdings in favour of EUR bonds, with spillovers to bond pricing. The analysis combines EMIR data on the universe of USD-EUR forwards and swaps with ECB securities holdings data, showing euro-area non-bank investors hold around EUR 2 trillion in USD bonds and hedge about 40% of this exposure using short-dated derivatives with an average maturity of 2.3 months versus 8.9 years for the bonds, while the gross USD-EUR derivatives market totals around EUR 8 trillion. In instrumental-variable estimates, a 1 bp widening of the cross-currency basis is associated with a 2% fall in FX derivatives positions and a 0.32% decline in holdings of an average USD bond relative to EUR bonds, implying roughly EUR 100 billion of USD bond sales for the largest 5% of basis shocks; effects are strongest for investors with high FX rollover risk and for mutual funds with FX hedging mandates. On prices, the paper estimates that USD corporate bonds held by high rollover-risk investors see yield spreads rise by about 1.6 to 1.8 bps per 1 bp basis widening, while euro-area government bond yields fall for bonds with greater exposure to such investors.