Roots of the Spreading Currency War: Part 2

Quantitative easing (QE) became the preferred non-standard policy tool among central bankers starting in 2007 as more and more large central banks reached the zero interest rate policy bound and were forced to become more creative. Regardless of where you stand on the issue, it goes without saying that without the implementation of QE, the global economy would still be in tatters. 

Over the past several years, the Fed hasn’t been alone in its efforts to weaken its currency to help domestic exporters. For example, the Bank of England has expanded its monetary base by five times since 2008; the Swiss National Bank implemented a currency floor for the Swiss Franc against the Euro to stabilize trade.

In 2013, the most notable offender has been the Bank of Japan, who in an effort to pull the country out of a two decade long deflationary spiral (Japan has been (in)famously mired in a more-than-two decades long deflation spiral) has pulled the rug from under the Yen quite literally. From January 1, 2008 to November 14, 2012, the Yen had rallied by +43.21% against the British Pound; +38.14% against the Euro; and +28.97% against the US Dollar. Since mid-November, when it became clear that Shinzo Abe would rise to power as prime minister, the Yen has been ‘competitively devalued’: it lost -20.42% to the British Pound; -26.69% to the Euro; and -23.52% against the U.S. Dollar.

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Clearly there is a distortive effect by ultra-easing policies on FX markets. The effects are not limited, however, as investors’ risk tolerance is completely altered. Consider the performance of the U.S. equity market the S&P 500 (yellow) compared to the size of the Federal Reserve’s balance sheet ($M) (white). The rally in U.S. equities – the benchmark for high-grade risky assets – can be wholly attributed to the rising Fed’s balance sheet, as the chart above implies.

Now that the BoJ has engaged in QE, the Nikkei 225 stock index is soaring, up +32% in 2013 thus far. With the BoJ’s QE plans in place for at least the next two years, investors will continue to jettison Yen-denominated assets in search of yield. But this brings us back to the earlier point about trade: the weaker Yen means that major trading partners, such as the United States, the Euro-zone, and Australia and New Zealand, will have to enact counter measures to prevent their domestic exporters from bearing the pain.

On several occasions early in the year RBNZ Governor Wheeler commented that the elevated New Zealand Dollar exchange rate was hurting the nation’s manufacturers, while noting his desire to “smooth the peaks” in the high yielding currency. These efforts have been minor thus far, and yet the New Zealand Dollar is barely dislodged. There’s little reason to think the RBNZ is going to be able to turn the tides anytime soon.

If there is one thing we can expect with a fair degree of certitude, it’s that competitive devaluations are here to stay for the next several years. The Fed is doing it, the BoJ is doing it, and as time passes, more and more central banks will be forced to engage in ultra-easy monetary policy.

Roots of the Spreading Currency War: Part 1

The global economy has seen fits of growth and contraction the past few years, with the developed Western economies struggling to regain solid footing. In the post-global financial crisis world, emerging markets, specifically the Asian-Pacific region, has been a driver for global growth. But if we step back from the trees and look at the forest, it’s clear that without central bank interventions, the global economy would be in much worse shape.

Since late-2011, if you turned on the TV, you probably heard pundits describe monetary policies being implemented around the world as stoking a “currency war” between developing economies. Mention the phrases “QE” and “currency war” in the same sentence and you’ll likely hear one of two answers: the Federal Reserve fired the first shots; while others, especially more recently, have pointed to the Bank of Japan as the most egregious offender.

Regardless if it was the Fed or the BoJ, the fact remains that most major central banks are currently engaged in or are moving closer to policies that result in the devaluation of their currency. Accordingly, it’s best to get acclimated with the idea of a “currency war” because it’s going to be showing up in newspapers and on financial television shows for the next several years. For good reason: the budding currency war impacts short-term speculators, bonafide hedgers, and long-term investors alike.

Recently, the Reserve Bank of New Zealand entered the fray, with Governor Graeme Wheeler acknowledging that the central bank had intervened in the market on various occasions since February. Reports have circulated that the RBNZ sold between N$30M and N$200M during its intervention efforts, which we can say retrospectively had short-term bearish implications for the Kiwi. Governor Wheeler has an incentive to try and weaken the New Zealand Dollar: its elevated exchange rate across the G7 currencies makes New Zealand products less competitive.

Macroeconomic theory states that a weaker domestic currency makes domestic goods more appealing to foreign consumers, who then consume more of the domestic good rather than their own country’s goods. The increased exports from the domestic country to the foreign country lead to a trade balance surplus, leading to higher growth in the domestic economy and weaker growth in the foreign economy. Thus, any form of an intentional devaluation to a currency – a competitive devaluation – is a shot fired in the currency war.

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While the RBNZ’s participation in the currency war will likely be a futile effort, the steps taken by the BoJ are far from immaterial. The combined efforts of the Fed and the BoJ alone the past few months have sent the aggregate global stimulus pool from $13,700B to near $14,000B between early-March and early-May. These policies are likely to continue into the near-future, with the Fed printing $85B/month to absorb agency MBS and U.S. Treasuries, while the BoJ has pledged to inject approximately ¥140T (¥7T/month).

What does this mean for the New Zealand Dollar? For one, it means that the RBNZ is a small fish in a pond with much bigger fish.

The next article takes a look at how QE distorts investor decision making, and how the BoJ’s interpretation of aggressive easing will impact the Asian-Pacific currencies.

New derivative valuation tool released to assist auditors with IFRS 13 compliance

Today Hedgebook announced the launch of Hedgebook Audit, an online derivative valuation tool designed specifically for use by auditors.

Hedgebook CEO Richard Eaddy says “we’ve had a number of conversations with CA firms around the world and it became evident that most simply do not have access to the tools they need to calculate or validate fair values of even vanilla currency, interest rate or commodity derivatives.”

“The implementation of IFRS 13. and the rigour that this brings to the calculation of fair values, means that the requirement for truly independent valuations is greater than ever. Bank supplied valuations just don’t cut it anymore” says Eaddy.

IFRS 13 was implemented at the start of 2013 and defines fair value on the basis of an ‘exit price’ notion and uses a ‘fair value hierarchy’, which results in a market-based measurement.

“We’ve worked closely with key personnel within audit teams to understand what this means to them and what their requirements are. They recognise that their processes are going to need to change so we have developed Hedgebook Audit based on the insights that these interactions generated,” continues Eaddy.

Hedgebook Audit is a cloud-hosted application that gives audit teams access to accurate, independent fair values for a large range of currency, interest rate and commodity instruments, whether in the office or out in the field. A client’s portfolio is recorded in the system and can then be valued quickly either individually or as an entire portfolio.

Hedgebook is available on a monthly subscription. For more information please contact us at

The Euro-zone Debt Crisis’ (Diminished) Impact on the Euro: Part 4

This is the final post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This final post will lay out the political roadmap for the Euro-zone through the 3Q’13.

While the financial aspect of the crisis has been relegated to the sidelines thanks to crafty policy signaling by European Central Bank President Mario Draghi, the economic aspect of the crisis remains a recurring issue. Hampered by German demands to keep austerity implemented in the periphery countries, the Euro-zone faces low inflation, contracting economies, and spiralling unemployment rates, the imperative to resolve the region’s problems falls with the ECB. True, the ECB has cut its main refinancing rate to 0.50%, an all-time low, but it’s clear that monetary policy, at least in its current form, may be losing its punch.

The big caveat – the finger holding the dyke together – is Germany’s demand for austerity in the debt-stricken economies of Greece, Italy, and Spain. What’s behind the dyke? A wave of fiscal stimulus that could go towards boosting the region’s economic prospects, particularly on solving the labour market problems persisting, could hit in several months. Whose finger is holding the dyke together, the wave of fiscal stimulus back? German Chancellor Angela Merkel.

It is Chancellor Merkel’s fault if the Euro depreciates midyear, just as it will be to her credit if it appreciates towards the end of the year. In September, Chancellor Merkel will be up for reelection, and given the rising anti-bailout sentiment in Germany, she is forced to maintain a hard line policy on spending cuts and tax hikes in peripheral nations in order to please her electorate.

The German election in September is not the only event to keep an eye on; the road until then, which could be a point of relief in the crisis, has several obstacles along the way. The calendar below shows not only upcoming elections in Europe, but also key meetings and data to keep an eye on the next several weeks and months that could directly impact sentiment regarding the Euro, thus, influencing hedging decisions.

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The Euro-zone Debt Crisis’ (Diminished) Impact on the Euro: Part 3

This is the third post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This third post will continue the examination of the economic challenges resulting from the crisis and how regional policymakers intend on addressing them.

Keeping in mind the chart from the first post in this series, the chart below gives prescient insight into how the ECB’s future policy actions will drive the Euro. We know this to be the case because market participants have already exhausted their enthusiasm towards peripheral European debt, and if yields creep back up as the economics remain a lingering problem, there is only one option for the ECB: expand its balance sheet.

ECB Balance Sheet

The above chart shows the ECB’s total balance sheet assets (€B) (white) plotted against the EURUSD (yellow – inverted Y-axis). The relationship expressed suggests that the greater the size of the ECB’s balance sheet, the weaker the Euro is versus the U.S. Dollar. We actually can even take away the point that as the ECB’s balance sheet contracted significantly (approximately €500B) between late-December and late-April, the EURUSD only rallied slightly. However, as the ECB’s balance sheet expanded dramatically in late-2011 through mid-2012, the EURUSD fell in line.

Accordingly, with yields suppressed in the near-term, we suggest that any further action the ECB takes will necessarily result in the reexpansion of its balance sheet, which will weaken the Euro in the short-term, despite the implication of longer-term benefits (market participants will need to see it to believe it before they can buy into a stronger Euro). In recent weeks, as significant PMI survey reports fell below consensus forecasts and evidence of increased erosion in Italian, Greek, and Spanish labor markets was released, chatter has arisen the ECB is exploring the idea of implementing a program similar to the Federal Reserve’s TALF, or Troubled Asset Relief Program, in 2008.

The TALF absorbed $200B of bad loans from American banks beginning in late-2008, thereby allowing them to unfreeze credit and resume lending to individuals and smaller enterprises. The ECB hopes to replicate the results with a potential SME lending program, or a facility for small- and medium-sized enterprises to restore credit flow to the Euro-zone economy. The program could take the shape of outright loans, which would likely have an admittedly smaller impact on the Euro and even could be positive. But what’s more likely is that the ECB utilizes the tried and true model of the Fed, opens its balance sheet and absorbs bad debt, and lets the Euro’s exchange rate suffer.

This may not be bad. According to data manipulated by Barclay’s Capital, a -10% decline in the EURUSD exchange rate would help boost Euro-zone exporters’ competitive edge, leading to a +0.75% to +0.80% boost in GDP. Long-term, when the Euro-zone economy recovers, so too will the Euro. But in the near-term, any depreciation that takes place will be at the hand of a very willing ECB – President Draghi said last week that the central bank stands “ready to act” – an ECB that will sacrifice its balance sheet for the sake of restoring credit flow to the Euro-zone. Continued downside pressure on the Euro into the 3Q’13 is likely as a result.

The final article in this series will examine the political aspect of the crisis and the upcoming calendar of Euro-zone-specific events that all market participants, both speculators and bonafide hedgers alike, will need to be aware of over the coming months.

The Euro-zone Debt Crisis’ (Diminished) Impact on the Euro: Part 2

This is the second post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This second post will examine the economic challenges resulting from the crisis and how regional policymakers intend on addressing them.

With borrowing costs in the periphery of the Euro-zone at multiyear lows, and in some cases, all-time lows, it’s difficult to say that the financial aspect of the European sovereign debt crisis is still an issue. The previous post in the series illustrated how the plunge in short-term Italian and Spanish government bond yields has helped keep the Euro afloat. Certainly, the relieved pressure didn’t materialize by its own doing; instead, that credit can be attributed to the European Central Bank.

After a rocky start to his tenure as president of the ECB, Mario Draghi daringly declared in late-July 2012 that he would do “whatever it takes” to save the Euro. On July 24, the EURUSD had hit a two-year low at $1.2041, with the Italian 2-year note yield approaching 4.000% and the Spanish 2-year note yield approaching 6.000%. Within two weeks, the ECB had announced that it was discussing the technical details of a program to inject funds into secondary bond markets. On September 6, the ECB announced that it was creating the Outright Monetary Transactions (OMTs) policy, intended to “aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy.”

Essentially, the ECB was saying, “our monetary policy has been hindered because of high sovereign debt yields in the periphery, and if we are to properly stimulate the economies of the region, we’re going to need to bring down those borrowing costs.” This has been a very important development for investors’ psychology – the ECB had threatened to be the largest buyer in secondary markets if bonds kept eroding. The logic for any trader was simple: get out of the way. Italian and Spanish yields plummeted, and the Euro rallied.

In recent weeks, with Italian and Spanish short-term debt lingering at multiyear and all-time lows, the Euro hasn’t been able to appreciate, a surprising development. This speaks to the financial aspect of the crisis being resolved. But it also speaks to the economic aspect of the crisis, which remains a significant lingering problem. The unemployment rate has crossed the 25% threshold in Greece and Spain, and is well on its way towards 30%. In Italy, a fractured government, walking the tightrope of limited mandate, can do little to address the accelerating labor market erosion besieging Europe’s third-largest economy: the unemployment rate is now above 12%, the highest ever.

If labor markets need revival, what’s the best way to do so? To find jobs, of course! How do businesses get started or expand? By borrowing on credit from banks. This is especially true for small- and medium-sized enterprises, the foundation of Western-styled developed economies. As the crisis proliferates, Euro-zone banks have been unable to provide necessary financing. Enter the ECB, which unfortunately may be bad news for the Euro. That’s the catch-22 for the Euro and the ECB: in either case, the Euro may suffer and could very-well fall towards 1.2000 versus the U.S. Dollar by the end of the 3Q’13.

Part three of this series will expand on this post’s initial discussion of the ECB’s policies, with an explanation of how renewed efforts could negatively impact the Euro.

The Euro-zone Debt Crisis’ (Diminished) Impact on the Euro: Part 1

This is the first post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This first post will examine the financial aspect of the crisis.

The first several months of 2013 have been a far cry from the norm that developed in 2011 and 2012 for the Euro. While the past few years have been marked by heightened volatility for the Euro, shifting crisis management tactics have afforded the Euro-zone some time in getting its act together with respect to the sovereign debt crisis, now entering its fourth year of excess sensitivity. Case and point: the Euro was the top performing major currency on February 1, peaking at $1.3710 against the U.S. Dollar; now it finds itself fighting to stay near 1.3000.

While the EURUSD has traded around the psychologically significant 1.3000 level the past several weeks, it has been far from an uneventful journey to arrive at our current juncture.

Italy was back in the markets’ collective crosshairs beginning in late-February, when voters elected a hung parliament, ending the career of Center-Left candidate Pier Luigi Bersani, the man who many believed to be the centrist politician to lead the Euro-zone’s third-largest economy back from the brink. The bureaucratic logjam was resolved when Italian President Georgio Napolitano, having just been elected to an unprecedented second term, granted Enrico Letta privilege to form a government. Mr. Letta’s rise to the premiership has soothed bond holders – perhaps the most important part of the equation.


Source: Bloomberg

Despite the Italian political crisis, the EURUSD has remained quite resilient, even overcoming a brief period of drama out of Cyprus. Given the relationship the EURUSD has held with short-term Italian and Spanish government debt, however, this isn’t a surprise. The chart above plots the EURUSD (white) against the Italian 2-year bond yield (orange – inverted Y-axis) and the Spanish 2-year bond yield (yellow – inverted Y-axis).

Back in August 2011, it was clear that the collapse in Italian and Spanish short-term bond yields (prices rallied) led the EURUSD higher off the low set on July 24 at 1.2041. Now, both Italian and Spanish short-term yields are at multiyear lows, with the former at all-time lows. This financial aspect of the sovereign debt crisis is no longer a problem for two major reasons, which is why the EURUSD has been able to sustain an elevated exchange rate thus far in 2013.

The one caveat: the ECB hasn’t had to actually use its ‘bazooka’ policy tool yet, the OMT. That’s why this is positive for the Euro: on a relative basis, the ECB’s balance sheet stays smaller than other central banks’. Thus, as long as the ECB can keep a lid on the financial aspect of the crisis without having to implement its version of QE, the Euro stands to benefit. So the big questions are: will the ECB implement its version of QE (or otherwise)?; and, what could provoke it to do so?

The next post in this series will examine the ECB’s role in the crisis, how it is evolving, and what policy changes in the future could mean for the Euro’s exchange rate. By identifying these factors, we’ll have a better idea of whether or not that Euro will appreciate or depreciate, and we’ll be able to decide if hedging this currency risk is necessary.