Eurozone Real Output and Covered Interest Parity Deviations: Can Stronger Real Output Lessen the Deviations?

Evidence shows that covered interest parity deviations have expanded over time in the EUR/USD cross currency basis swap market – the world’s largest basis swap market – even across the less erratic long-end of the basis swap curve. We analyze the long-run impact and dynamic interdependencies of eurozone macroeconomic factors on the long-end of the EUR/USD cross-currency basis swap spread, utilizing quarterly data from 2003–2018. Our stylized model predicts that a rise in euro area real output relative to the US would lead to a tighter euro basis swap spread; however, an increase in euro area money supply relative to the US as well as a depreciation of the euro would widen the euro basis in the long run. Our model suggests that the magnitude of the effect of real output on the basis is particularly more pronounced than the magnitude of the individual or combined effect of money supply increases and euro depreciation on the basis. Interestingly, our empirical results are consistent with these predictions. In addition, after examining convergence to long run, we find that among the eurozone variables, it is the cross-currency basis that is the predominant adjusting variable in the event of a divergence from the estimated long-run relation. Finally, using accumulated impulse response, we show that shocks to the exchange rate which strengthen the US dollar have permanent effects on the basis.