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.

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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.

Hedgebook acquires financial data services company Infoscan

We’re pleased to announce our acquisition of New Zealand-based financial data services company Infoscan.

In a move designed to augment the existing Hedgebook offering as well as create new IP, we see the acquisition as a key step in our expansion into international markets.

With an offering that now encompasses our flagship Hedgebook Pro cloud-based treasury management, Hedgebook Audit (our valuation tool designed for auditors), Excel-based modelling tools, rate feed packages and mobile solutions, we feel we are now well positioned as one of the leading providers financial derivative management solutions.

“This acquisition is an important step in Hedgebook’s growth. It extends the Hedgebook offering, creates economies of scale and allows us to innovate with the combined Hedgebook-Infoscan technologies.” says Hedgebook director and Xero co-founder Hamish Edwards. “Our first priority is to make sure that the transition is a positive one for current Infoscan customers. From there we will be working hard to bring new products to market that take advantage of the combined IP that we now have in our kitbag.”

Hedgebook CEO Richard Eaddy is equally excited about the acquisition. “We have worked with Infoscan as a provider of data for the Hedgebook products for some time now. This acquisition made sense on many levels as it allows us to deliver greater value to Hedgebook and Infoscan customers, and it also means that we now have one of the most comprehensive sets of derivative management tools available” says Eaddy. “We feel that this acquisition positions us well in a growing market.”

The opportunity created by new accounting standards was a key driver for our Infoscan acquisition. “With IFRS 13 coming on stream, the rigour that companies need to apply to accounting for financial derivatives has gone to another level. Tools like Hedgebook that offer the ability to quickly gain independent valuations will be an important part of a finance team’s toolkit,” says Eaddy.

Hedgebook releases cloud-based derivative valuation tool to help auditors with IFRS 13

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.”

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.

Australia’s Reliance on China Puts Aussie at Risk

The Reserve Bank of Australia cut its key benchmark interest rate to 2.75% at its policy meeting in May, underscoring the fragility of the Australian economy as it remains heavily reliant on emerging market growth for support.

Now, with rates at all-time lows, it’s a good moment to reflect on why we’re in the current predicament. After all, dovish monetary policy is only implemented when worries of an economic slowdown persist. The RBA has been cutting rates furiously since November 2011, when its main rate was 4.75%. Yet despite these efforts, the following chart raises two major concerns for Australia.

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Over the past two years, after the AUDUSD peak near $1.1100 in the summer of 2011, the RBA began an aggressive easing cycle that continues today. Yet over this time, the AUDUSD (yellow line) has remained relatively stable – in the past twelve months, it has traded in a roughly 5% band, between 1.0100 and 1.0600.

What hasn’t remained stable has been Australia’s unemployment rate, which has shot up six-tenths of point over the same time frame. Despite several rate cuts the past few years, Australia’s unemployment rate has increased from 4.9% in April 2011 to 5.6% in March 2013, the highest rate since November 2009.

While volatile labor market readings the past several months have unnerved policy officials, such activity is likely to continue as the mining sector peaks, which according to the RBA and government officials should be this year. That’s why the chart above is concerning: the RBA has already done a great deal to help insulate the economy from a slowing China (discussed in the previous post) and yet the labor market is still suffering.

The other concern raised about the Australian Dollar is the fact that it is one of the few major currencies that offers any semblance of yield. With risk appetite buoyant in recent months, this “reaching for yield,” as Fed Chairman Ben Bernanke has described it, has pushed up the prices of Australian (and New Zealand) sovereign debt.

Article 8a

This perspective feeds back into the discussion from an earlier post on “currency wars.” Investor decisions are being altered because of non-standard monetary policies across the globe, forcing secondary policymakers and consumers (like those in Australia and New Zealand) to change their behavior.

To combat the flow into the Aussie and Australian debt, the RBA recently suggested that the high exchange rate of the Australian Dollar has become problematic: the Aussie “has been little changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates.” Just like the RBNZ, the RBA is being forced to engage in a loose form of competitive devaluation by repeatedly cutting rates and talking down the exchange rate of its currency.

 

 

Year of the Snake: Not the year for strong Chinese growth

As China gets ready to overtake the United States as the world’s largest economy during the middle of the current decade, leaders have had to lead a tricky transition from a centrally-planned state to a free market. A major part of that task is to fill out the middle class that would support a consumption-based economy. But with base metal prices falling and the commodity currencies losing value in recent weeks, concerns over the Chinese growth picture have been stirred.

There’s one major caveat to Chinese data that is truly inapplicable to any other global economic force: you just don’t know if you can trust it. Chinese data seemingly comes out of a black box, where Chinese government readings of the economy tend to outpace private sector readings, or even eclipse foreign government estimates of economic activity.

One recent prominent example of this manipulation emerged in early-May when Chinese trade data showed an incongruent jump in exports despite declining orders to both Europe and the United States, China’s two largest markets. This discrepancy isn’t just our observation. According to researcher IHS Inc. via Sprott Group, “an “astounding” +92.9% jump in exports to Hong Kong, the most in 18 years, raises questions on data quality.”

Putting away our tinfoil hats for a moment, even if there’s no misinformation afoot, Chinese growth is slowing down. Presently, there are no indications from Chinese policymakers that they will try and stimulate their way out of this spell of moderation. Given recent rhetoric, it’s very unlikely that any such measures are taken at all, now or over the rest of 2013.

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The days of “ultra-high speed” growth were in the past, Chinese President Xi Jinping said in early-April. Similar sentiment was promoted by Prime Minister Li Keqiang, who has said that China may have to accept annual growth rates below +7.0% in the coming years. Recent gauges of manufacturing activity suggest that 2Q’13 growth might edge lower towards +7.5% annualized. The HSBC services PMI index fell to 51.1 in April from 54.3 in March, suggesting that the slowdown is not just limited to the manufacturing sector. If there’s one indicator that may confirm these views, it is the Chinese Consumer Price Index.

The chart above illustrates the annualized Chinese inflation rate (yellow) against annualized Chinese GDP (white). The slowdown in Chinese growth accelerated in mid-2011 once price pressures started to fall, a sign that overall demand in the economy was weakening. Now, inflation has fallen by around four percent, tracking GDP’s diminished rate of +7.7% annualized from near +10.0% just two years earlier.

While it appears that the market and policymakers are going to push Chinese growth lower, the ripples these waves will create will be exceptionally important for the global economy. Already, signs of slowing Chinese growth have negatively impacted the Australian economy, where policymakers cut the main rate to a record low 2.75% in May.

The reasons behind the Reserve Bank of Australia’s rate cut are critically important, and are why we believe that, thanks to China, the Australian Dollar could suffer in mid-2013.

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 enquiries@myhedgebook.com

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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