The Dollar's Double Life: Not All Dollar Appreciations Are Born Equal for the Cross-Currency Basis

This paper revisits the relationship between the US dollar and cross-currency basis (XCB) swap spreads. We show that the strength and direction of this relationship depend on the prevailing regime of the broad dollar. The evidence suggests that the well-documented “dollar appreciates, basis widens” result holds primarily when the dollar is in a low or intermediate regime. However, once the dollar transitions into a high regime, this association either weakens or reverses: a stronger dollar no longer widens the basis and may tighten it. Our findings reveal that not all dollar appreciations are created equal. For the same magnitude of dollar appreciation, basis spreads tend to widen significantly more in low- or intermediate-dollar regimes than in high-dollar regimes. We explain these results through a theoretical framework grounded in hedging demand and supply imbalances and validate them empirically using the term structure of XCB swap spreads of G10 currencies.