When covered interest rate parity breaks down - we have a credit problem!

When a textbook example of arbitrage is called for, covered interest rate parity (CIP) is often used as the perfect case. The interest differential between two countries for the same maturity will be equal to the percentage differential between the forward and spot rate. The only reason this would not hold is if there are structural impediments for the flow of capital or transaction costs that will limit the ability of arbitrageurs to make a sure profit. There is a long history of this relationship holding across most countries that do not have explicit capital controls. Nevertheless, there are times when CIP does not hold.

Periods of market turmoil especially in the banking system will place limits on the amount of arbitrage that can be done which leads to deviations in CIP. The post-Lehman period saw significant dislocations which was only stopped by the intervention of the Fed through supplying swap lines. Another period of dislocation was during the EU debt crisis as European banks pulled back lending dollar funded lending.

The BIS advisor and head of research, Hyun Song Shin has noted that we are in another period of CIP breakdown. See "Global Liquidity and Procyclicality". We take note of this breakdown because this is both a warning sign for the markets and an opportunity for those that want to take advantage of market dislocations. It is also a period of relative calm in the financial markets.

His argument for the CIP breakdown is driven by capital flows but is still one associated with limits of arbitrage and a dollar funding shortage. Given bank funding requirements and hedging, a dollar gain will negatively impact the ability of foreign firms who need dollars to fund in dollars.

When the dollar rises, there is more credit risk in other parts of the world for sovereigns and corporates who need dollars and have assets dominated in the foreign currency. The currency swap basis will widen. We will see CDS spreads move with the dollar. A currency swap basis disruption is like a seismic tremor. It could be a signal of a potential financial earthquake.