[ForexNews]

An interesting article (http://www.newyorkfed.org/research/c...s/ci15-16.html) called The Global Financial Crisis and Offshore Dollar Markets by Niall Coffey, Warren B. Hrung, Hoai-Luu Nguyen,and Asani Sarkar argues that international firms “increasingly turned to the foreign exchange swap market and other secured funding sources when USD liquidity dropped during the crisis” and that the run-up in USD basis came “chiefly as a result of the higher funding costs paid by smaller firms and non-U.S. Banks.” Their argument is basically that there were USD assets on the balance that had to be funded and that credit dried up, implying a squeeze.

It is tempting to go from the above conclusion to the conclusion that the USD funding shortage was a cause of USD weakness (although the authors do not draw this conclusion and do not comment on currency moves). However there is a very vague correlation between the moves in the USD basis and EUR, and a much tighter one between the S&P and EUR. In particular while there seems to have been one episode in December when the narrowing in basis appeared directly (but briefly) correlated with EUR strength, earlier in Q4 08 and throughout 2009 the correlation is very weak. By contrast S&P moves (which is used as a loose proxy form market risk aversion and risk appetite) are much more consistently correlated. Why is the case? It is possible that while the absence of USD funding was the cause of the widening in basis, buying of USD by a foreign investor would have substituted currency risk for the problems in the credit market. While paying up was unpalatable, relative to the risk of sharp currency moves, the risk premium was relatively inexpensive. Hence the broader picture seems to be one of a general correaltion of USD weakness and risk appetite that persists.