Real Output and Cross-Currency Basis Swap Spreads: Evidence from the Eurozone

Abstract

Can higher real output tighten covered interest parity (CIP) deviations and lessen arbitrage profits in the eurozone fixed income market for dollar-based global investors? We address the question of determining the long-run links between selected eurozone macroeconomic factors and the long-end of the EUR/USD cross-currency basis swap spread. In our stylized model, a rise in eurozone relative real output tightens the cross-currency basis and hence lowers available arbitrage profits for USD investors looking to execute arbitrage trades whereas an increase in relative money supply together with euro depreciation widens the basis and increases potential arbitrage profits. The magnitude of the effect of relative real output dominates the magnitude of the individual effects of relative money supply and exchange rate. Our empirical results are fully consistent with the stylized model.