USD cross-currency basis - an added cost for Swiss investors

• Many Swiss investors routinely hedge foreign currency exposures in order to reduce portfolio volatility and reduce the risk of disaster scenarios. In doing so they incur a structural hedging cost against most major currencies, the US dollar in particular.

• This cost is typically thought of as being equivalent to the interest rate differential, which is currently near a record high - US rates are still well above 4% and Swiss rates are just below 1%. But on top of this, there is also another factor that makes it even more expensive for Swiss hedgers - the cross-currency basis. This factor increases the actual cost of hedging beyond the interest rate differential.

• The cross-currency basis refers to the difference between the actual tradable market rate of a foreign exchange forward or swap and the rate implied by the interest rates of the two currencies.

• The basis results from a variety of factors that have emerged since 2008 and have permanently changed the market structure and conditions [more on this in a future note]. It has fluctuated over time but almost always has a negative impact for foreign investors hedging US dollars in particular.

• In the last couple of years, the Federal Reserve has become attentive to signs of market stress expressed in the cross-currency basis and has alleviated spikes by making dollars available to foreign central banks through currency swaps. We will see whether this continues in the new US environment, in which global cooperation may be less of a priority.

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