Emerging Markets Meltdown: Is Another Asian Crisis Brewing?

Concerns over a 1997-redux are brewing. The parallels are staggering. Asia is facing growth pressure. Emerging markets are going belly up. Currencies are rapidly deteriorating as the Federal Reserve considers monetary tightening. Japan is on the verge of fiscal tightening. These are all the same ingredients that led to the 1997 Asian crisis. Are we looking over the edge, or is there hope to avoid another financial crisis?

First, a look at emerging market currencies: they’ve been hammered in 2013 far too similar to the pain seen in 2008. The Indian Rupee hit its lowest exchange rate ever against the U.S. Dollar in the 3Q’13; the Indonesian Rupiah is halfway back to its lows; the Brazilian Real is a few percent away from its lows; and the Turkish Lira, burdened further by recent political discord, it at its lowest levels ever.

Emerging market currencies

So much for the “carry trade,” of which all of these currencies are considered.  Why? They have higher yields. They are expressed in the form of the sovereign bonds. It is important to distinguish the difference between “higher yields” and “higher yields.” Stick with us – there’s a clear distinction.

Higher yields are used to refer to two, opposite situations: one in which a country, with more obvious inherent risk (politically, economically, socially), offers a “higher yield” but is considered a worthwhile investment given the optimistic projected path of the economy – economic liberalization, a stable political environment, reduced risk for violence. The aforementioned emerging market economies share these characteristics: optimism for a brighter future.

10 yr gov bond yields

The other type of “higher yield” is when there is panic. There is no optimism for a higher future; higher yields result from investors selling the bonds (bond prices and yields are inversely correlated). This can result from a number of influences – war, higher inflation, political instability – as well as the threat of reduced liquidity. The higher yields we’ve seen in these emerging market economies over the course of 2013 represents the wrong type of higher yield, predicated on exogenous circumstances – the Federal Reserve winding down its stimulus program .

Does this mean that another 1997 Asian crisis is upon us? Possibly, maybe among the BRICS. As the chart to the left shows, international claims to GDP – foreign banks’ lending – is rising at a pace that puts it on par to where the Euro-Zone was three years ago. It also puts the BRICS on par with the Asian financial crisis in 1996/1997. These are concerns that must be monitored considerably in the weeks ahead. Excess volatility will greatly enhance the need to reduce portfolio risk through hedging.

Foreign banks lending

Charts courtesy of the RBA’s August Statement on Monetary Policy.

Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.

Weakening Correlations Suggest Time to Diversify

As we know, risk correlations tightened up (became increasingly positively correlated) during the financial crisis, where we saw very many near-perfectly positive correlations (>=+0.80) among the major asset classes: AUDUSD and Gold; NZDUSD and SPX; USD and DJIA; and JPY and US Treasuries among others.

In recent weeks (especially since the 2Q’13), we’ve since seen these correlations break down – perhaps the NZDUSD relationship with U.S. equities and New Zealand equities best serves this example:

NZDUSD correlation breakdown with equities

NZDUSD correlation breakdown with equities


Why does this matter? When correlations tighten up towards being perfectly positively or negatively correlated, there’s little benefit to diversification. IE, there’s no reason to invest in the NZDUSD if I’m long a basket of equities/S&P 500 as it’s essentially the same trade already. However, when risk correlations break down, the benefits of risk diversification increase. IE, there’s reason to trade the AUDUSD if you are long a basket of equities/S&P 500 because it reduces overall portfolio risk (general Markowitz/modern portfolio theory).

Thus, equity traders may find it appropriate now to start looking for ways to diversify, or hedge, risk. For the better part of the past few years, the NZDUSD has had a strong positive correlation with equity markets at home and abroad – the NZX 50 and the S&P 500 recently saw 52-week rolling correlations against the NZDUSD above +0.80 early in the 2Q’13.

As U.S. yields have risen thanks to a less dovish Federal Reserve and overall strengthening economy, the strong NZDUSD-equities correlation has eroded. In fact, for the week ended September 6, the NZDUSD-S&P 500 correlation fell to -0.47 and the NZDUSD-NZX 50 correlation fell to -0.35. This means the New Zealand Dollar may have some value as a speculative investment vehicle going forward – it retains yield despite losing correlation with equity markets. Recall from an earlier post that the New Zealand Dollar has seen increasingly strong yields:

NZD-USD Yield Spread versus NZDUSD fx rate


By reducing your profile’s overall correlation, you actually stand to reduce risk to your overall portfolio and capture greater returns. Now may be the right time to hedge away equity risk – by diversifying into the New Zealand Dollar, the highest yielding major currency alongside the Australian Dollar.




The End of the Fed’s QE and its Impact on Markets: Part 2

This is the final of two posts on the impact of the end of the Federal Reserve’s quantitative easing (QE) program on markets, and it will focus on the impact on the “carry trade,” of which the New Zealand Dollar is considered. We will examine the outcomes for a reduction in QE3 and how it might impact FX markets.

The end of the Federal Reserve’s QE3 program may be approaching fast. Market participants have become increasingly anxious as to the next direction the world’s most influential central bank will take as it measures the health of the U.S. economy.

In the previous post, we examined how speculation over the Fed’s QE3 “taper” has caused clear misalignment in two key markets: bonds and stocks. This agitation has spread across the globe and has helped provoke the early stages of a Southeast Asia/emerging markets crisis  (covered in future postings), which has done nothing short but wreak havoc on assets deemed “risky.” Similarly, the “carry trade” has suffered as a “risky asset.”

What exactly is the carry trade? Investopedia defines it as:

“A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.”

Returns from carry trade strategies were serial outperformers for over three decades before the global financial crisis of 2008. Data from 1971 to 2005 illustrates this point clearly enough:

Article 2 Table

Not only did the highest yielding currency basket in this case study offer the highest average annual return over this time series, but by theoretically going long basket 6 – the highest yielding basket – while shorting basket 1 – the lowest yielding basket – investors would take in an annual return of 4.35%. Risk is compensated, too: the Long 6/Short 1 basket has the highest Sharpe Ratio among the seven samples.

The carry trade hasn’t been so kind this year. A typical carry pair in the wake of the global financial crisis – the NZDUSD – hasn’t produced the kinds of returns risk-seeking investors would have hoped for. And that’s simply because of the chatter around the Fed’s tapering of QE3. The New Zealand Dollar, as the highest yielding major currency (the Reserve Bank of New Zealand maintains a key rate of 2.50%, the same as the Reserve Bank of Australia now) and member of the commodity bloc, finds itself in the crosses.

It’s clear that concerns about the Fed winding down QE3 has been bad news for the New Zealand Dollar and the carry trade. After peaking above $0.8600 in April, the NZDUSD slid to as low as $0.7727 (on a closing basis) in late-August –  greater than a -10% drop in just over one quarter.

Article 2 Graph

Why has this type of volatility returned? Higher U.S. yields have reduced the interest rate differential between the New Zealand and U.S. Dollars, and considering that once the Fed begins to exit it will be difficult for it to turn back, we can surmise that this instance of the carry trade – the NZDUSD – will struggle to find meaningful direction going forward. At this point, the only hope for any U.S. Dollar-funded carry trades is for a turn lower in U.S. Treasuries yields, and that might not happen if the U.S. economy improves and the Fed proceeds with tapering QE3.

The End of the Fed’s QE and its Impact on Markets: Part 1

This is the first of two posts on the impact of the end of the Federal Reserve’s quantitative easing (QE) program on markets. The recent iteration, QE3, is expected to slow over the next few months. This first article will examine what has happened to U.S. financial instruments and what to expect going forward.

On May 22, 2013, Federal Reserve Chairman Ben Bernanke tapped his microphone in front of a U.S. Congressional testimony and said, “If we see continued improvement and we have confidence that that is going to be sustained, then in the next few meetings, we could take a step down in our pace of purchases.”

With the first hints of ending the Fed’s most recent iteration of QE3 – a combined $85B in monthly asset purchases ($40B in agency mortgage-backed securities, $45B in outright U.S. Treasuries purchases) – a tectonic shift in global markets began. As is often the case, bond markets have led the way ever since late-May.

US Economy Improves

The blue area on the above chart highlights the performance of the S&P 500 and the U.S. Treasury 10-year note yield between May 22 (when Fed Chairman Bernanke first warned about “tapering”) and June 19 (when the Federal Reserve’s official policy statement suggested that a reduction in QE3 could occur at some point over the next several months.

The area highlighted is important because it frames the QE3 taper conversation in context of a strengthening US economy. After mid-June, US economic data started to disappoint. Ironically, this has been due to…higher yields (interest rates).

Indeed, a stronger U.S. economy prompted the Fed to look to wind down QE3, pushing up yields, which in turn caused the economy to slow down during the summer. Likewise concerns that the Fed has begun to see certain asset classes as too ‘bubbly’ – bonds in particular after the Fed has added over $3 trillion to its balance sheet over the past five years – exacerbated rising yields.

This remains a logical reaction: the largest buyer of U.S. Treasuries the past five years is suggesting that it will reduce its uptake; demand will fall and price will too as a result. Market participants have been simply front-running the Fed by selling their U.S. Treasuries holdings ahead of any official announcement.

Outside of the shaded area on the chart, there is an observable pattern: even as the S&P 500 has scrapped its way back towards all-time highs, it struggles mightily when U.S. yields move higher. Only when U.S. yields have consolidated over several days or weeks since early-July – in particular the U.S. Treasury 10-year note yield as seen on the chart – has the S&P 500 been able to advance. (This link will remain true, even if the Fed chooses not to taper; lower yields will boost stock prices.)

The consequences of the Fed’s plans to reduce QE3 have serious implications for financial markets across the world, not just in the United States. Indeed, other asset classes’ own barometers of risk – in FX markets, the “carry trade” such as the NZDJPY or NZDUSD pairs – are showing signs of increased instability.

The next post on the end of the Federal Reserve’s QE3 will focus on the impact on the “carry trade,” which the New Zealand Dollar finds itself in the crosshairs. We will examine the outcomes for a reduction in QE3 and how it might impact FX markets.