How U.S.-EU Relations Could Impact The Cross Currency Basis

By Chris Farran

At a Glance

• Policy changes could impact the historically cooperative relationship between the Federal Reserve and the European Central Bank (ECB)
• The CME EUR/USD Cross Currency Basis Index tracks the nearest forward starting 3-month IMM period and can provide insight into relative changes in demand for either USD or EUR

As discussions around U.S.-EU relations move to the fore, various unknowns are still ahead. As market participants assess what could be next, it may be worth keeping an eye on CME Group’s EUR/USD Cross Currency Basis Index (XCCY). This index measures the basis point deviation from covered interest rate parity in the EUR/USD foreign exchange market.

Assessing Market Alignment

The Euro Short-Term Rate (€STR) and Secured Overnight Financing Rate (SOFR) not only provide the interest rate used to borrow money in their respective regions, but the spread between the two can reveal trends or preferences emerging in the foreign exchange market.

Since June of last year, the Three Month SOFR-€STR spread (measured by their respective nearby forward starting quarterly-IMM dated CME Group futures contracts) has both narrowed from 175bp to 100bp and subsequently re-widened to over 200bp. A higher spread is partly a function of Central Bank policy, but may also imply that USD liquidity is tighter than euro liquidity; a lower spread, the opposite.

During the same period, the X-CCY Basis Index has ranged from -13 bps to 2 bps. A X-CCY Basis Index value near zero means that interest rate markets and FX markets are aligned in their expectations of forward FX prices. As of February 7, 2025, the XCCY Basis Index was -0.49 – just a half basis point away from zero.

The daily correlation between these two measurements is 0.753 over this period, suggesting a moderately strong relationship between the SOFR-€STR spread widening and the XCCY Basis Index narrowing. Monitoring the X-CCY Basis Index could give insight into potential risks or arbitrage opportunities tied to the SOFR-€STR spread.

Policy Impacts?

Any change in U.S. and EU trade relations could affect euro and U.S. dollar money markets, and therefore, the EUR/USD cross currency basis. If policies create tension between inflation and economic growth in both the U.S. and the EU, it could make it harder for the respective monetary policymakers to set the level of short-term interest rates that would both contain inflation and enable economic growth.

In addition, there has historically been close cooperation between the Federal Reserve and the European Central Bank (ECB). For instance, the two central banks activated their existing USD swap line to provide liquidity during the initial days of the COVID-19 pandemic. A shifting economic posture between the U.S. and EU has the potential to re-write the rules of Fed-ECB relations.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.