Don’t shoot the messenger

We are only a week or so past 30 June (a common balance date for many Hedgebook clients) and already we are fielding questions/comments regarding the big movements in the mark-to-market valuations of our clients’ portfolios. The questions have nothing to do with the accuracy of the valuations but mostly around, “why has this happened?” Many of the big movements relate to our clients that hedge their interest rate risk via interest rate swaps.

It is no surprise given the sharp downward movements we have seen in the New Zealand and Australian yield curves over the last few months (see charts). A 1% move on a 5 year $5 million swap will result in a $250,000 move in the mark-to-market. Depending on the size of your swap portfolio, and the tenor of the swaps, the moves can be material.

NZD swap movements

AUD swap movements

An interest rate swap is a valuable hedging tool which helps companies manage their interest rate risk. Many companies have treasury policies which force them to have a proportion of fixed and floating interest rate risk which helps with certainty of interest cost as well as smoothing sharp interest rate movements, both up and down. However, there is also a requirement to mark-to-market swaps, and for many to post these changes to their profit and loss account. Some companies negate this profit and loss volatility by hedge accounting, but many don’t which often requires some explanation to senior management, directors and investors.

For publicly listed companies the impact, both real and perceived, of large movements in financial instrument valuations is even more critical. The requirement for continuous disclosure means that a large move in these valuations may require the issue of a profit warning, as we have recently seen from Team Talk, the telecommunications company. Team Talk’s shares dropped 6.3% on the back of the hit taken by a revaluation of interest rate swaps. The company noted that the change in the value of the interest rate swap portfolio was due to “wholesale interest rates falling significantly in the period”.

Equally we have a number of private companies and local governments who have been concerned at the change in their valuations and how they are going to be explained further up the tree. Having constant visibility over these changes will at least forearm any difficult conversations, as opposed to relying on the bank’s month end valuations.

Whilst Hedgebook won’t help improve mark-to-market valuations, it does assist with companies keeping abreast of changes in the value of swap portfolios on any given day. This is pretty much a “must have” for publicly listed companies that have the responsibility of continuous disclosure but forewarned is forearmed and many others are also seeing the benefit of having access to mark-to-market valuations at any time.

IFRS 7 – Disclosure Requirements of Financial Instruments

A key pillar of Hedgebook’s ethos is to make life easier for corporates in managing and reporting their financial derivative exposures. This approach extends to aiding Treasurers and CFOs comply with the ever increasing compliance requirements of accounting standards. The most recent standard to create further onus on corporates is the CVA requirements of IFRS 13. We have discussed IFRS 13 on numerous occasions via this blog (and will continue to do so!)

However, the focus of this blog post is the disclosures required by IFRS 7 and specifically the quantitative disclosures in assessing the risks faced by an entity in regards to its financial instruments. Quantifying the risks is demonstrated via a sensitivity analysis.

The Hedgebook application allows a user to perform sensitivity analyses on foreign exchange and interest rate positions at the press of a button and in doing so helps achieve compliance to IFRS 7 as simply and efficiently as possible. These numbers can be included directly into the Notes to the Financial Statements.

Interest Rate Swaps

There is a report within the suite of Hedgebook interest rate reports called the IR Sensitivity Report. A user is able to run the sensitivity analysis in three easy steps:

–          select the appropriate interest rate swap portfolio or individual deals

–          select the valuation date and currency

–          run the IR Sensitivity Report

The Hedgebook app produces the fair value per instrument based on the valuation date zero curve and also the fair values following pre-defined shifts in the yield curve.

Using the 31 March 2014 AUD zero curve as an example, the chart below shows the actual zero curve plus the alternative yield curves that are applied to the swap portfolio:

Sensitivity analysis

The zero curve is flexed by a parallel shift of +/-50, +/-100 and +/-200 basis points. The output of the report is the hypothetical fair value of each transaction under the aforementioned yield curves. The analysis provides information about the extent to which the entity is exposed to risk. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Foreign exchange

Hedgebook’s sensitivity analysis for fx instruments follows a similar vein to interest rates. The fx curve (spot plus forwards) is flexed by a +/-1%, +/-5%, +/-10% and +/-20% to derive the hypothetical valuations. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Summary

As regulatory and compliance requirements continue to increase it is important that corporates find ways to increase efficiency and find alternative ways to complete increasing workloads without increasing personnel. A low cost system such as Hedgebook allows senior members of the finance team to focus on added value tasks and not become encumbered by compliance requirements that can be automated such as sensitivity analyses for IFRS 7 disclosure requirements.

Calculating fx forward points

A common misunderstanding we often encounter relates to the calculation of foreign exchange forward points. Foreign exchange forward points are the time value adjustment made to the spot rate to reflect a future date. The forward foreign exchange market is very deep and liquid and is used by an array of participants for trading and hedging purposes. In the corporate world many importers and exporters hedge future foreign currency commitments or forecasts using forward exchange contracts (FECs).

The table below shows a selection of the forward points and outright rates for a number of currency pairs:

Forward points

Table 1: Forward points and outright rates

For example the NZD/USD 1-year forward points are currently -270, while the NZD/USD spot rate is 0.8325. Therefore, at today’s rates a forward rate of 0.8325 – 0.0270 = 0.8055 can be secured for a commitment or forecast in one year’s time. But how did the NZD/USD 1-year forward points come to be -270? The common misunderstanding is that they are traded like the spot rate i.e. based on currency traders’ views for the outlook of a currency’s fundamentals. This is incorrect. FX points are mathematically derived by the prevailing interest rate markets. Using our example of the NZD/USD 1-year forward points the -270 is a result of the 1-year US and NZ interest rate outlook. The NZD/USD is a good example because of the significant interest rate differentials between the two currencies. The aggressive monetary easing policies in the US have resulted in an extremely low interest rate environment. This contrasts with NZ which although has interest rates at historically low levels, they remain well above those of the US. The chart below shows the NZ interest rate yield curve versus the US and the corresponding fx forward points.

NZ and US int rates and fx points

Chart 1: NZ and US interest rates and the NZD/USD forward points

The interest rate market is telling us that the US 1-year swap rate is 0.25% while in NZ it is 3.45%. So how does this equate to -270 fx points?

Example

USD1,000,000 at a spot rate of 0.8325 = NZD1,201,201

If USD1,000,000 is invested for one year at a US interest rate of 0.25% per annum, at the end of one year USD1,000,000 is USD1,002,500.

If NZD1,201,201 is invested for one year at a NZ interest rate of 3.45% per annum, at the end of one year NZD1,201,201 is NZD1,242,643.

The equivalent exchange rate is NZD1,242,643 divided by USD1,002,500 = 0.8067.

0.8067 – 0.8325 = -0.0258 (or -258 fx points in the parlance of the fx markets).

The bid/ask spread of the fx and interest rate markets accounts for the 12 fx point balance. The example serves to provide a “back of the envelope” guide to calculating fx forward points and outright rates.

Even though the calculation of the forward points is mathematically derived from the interest rate market, interest rates themselves are the market’s expectation of the outlook for an economy’s fundamentals i.e. subjective. Therefore the fx forward points are derived from traders positioning on interest rate differentials.

Exporters from countries with higher interest rate environments such as New Zealand and Australia benefit from the negative forward points, while it is a cost to importers. An exporter wants a weak base currency so large negative forward points are an economic advantage. With an upward sloping interest rate yield curve (or more correctly positive interest rate differential) forward points will be more negative the longer the time horizon.

An importer wants a strong currency therefore negative forward points are detrimental to the hedged conversion rate. The impact of negative forward points is a reason that exporters often have longer term hedging horizons compared to importers because the impact of forward points are not penal.

Forward exchange contracts are therefore a flexible, and relatively easy to understand, hedging tool that is commonly used to bring certainty to those grappling with foreign exchange exposures and the volatility of the financial markets.

End of year derivative valuations improve for borrowers

The increase in interest rates over 2013 means that the 31 December 2013 valuations of borrower derivatives such as interest rate swaps will look much healthier compared to a year ago. The global economy certainly appears to have turned a corner through 2013 and this is being reflected in financial markets expectations for future interest rates i.e. yield curves are higher. As interest rates collapsed after the onset of the GFC many borrowers took advantage of what were, at the time, historically low levels. Base interest rates i.e. ignoring credit, were compelling and borrowers increased their fixed rate hedging percentages locking in swap rates for terms out to ten years. Unfortunately, as the global economy sank further into recession, interest rates fell further than most market participants expected. Consequently, derivatives such as interest rate swaps moved further out-of-the-money creating large negative mark-to-market positions.

The unprecedented steps taken by central banks in an effort to shore up business and consumer confidence, protect/create jobs and jump start lack lustre economies pushed interest rates lower for much longer. Through 2013 the aggressive monetary policy easing undertaken since 2008 (by the US in particular) has started to show signs that the worst of the Great Recession is behind us. The Quantitative Easing experiment from the US Federal Reserve’s Chairman Ben Bernanke appears to be a success (only time will confirm this). The labour market has strengthened, as well as GDP, in 2013 allowing a gradual reduction in Quantitative Easing to begin. Although the US Central Bank has been at pains to point out that the scaling back of QE does not equate to monetary policy tightening, merely marginally “less loose”,           the financial markets were very quick to reverse the ultra low yields that had prevailed since 2008.   The US 10-year treasury yield is the benchmark that drives long end yields across every other country so when bond markets in the US started to aggressively sell bond positions, prices dropped and yields increased globally. As the charts below show all the major economies of the world now have a higher/steeper yield curve than they did a year ago reflecting expectations for the outlook for interest rates. For existing borrower derivative positions the negative mark-to-markets that have prevailed for so long are either much less out-of-the-money, or are moving into positive mark-to-market territory.

Of the seven currencies that are included in the charts below, all display increases in the mid to long end of the curve i.e. three years and beyond, to varying degrees. Japan continues to struggle having been in an economic stalemate for 15-years so the upward movement in interest rates has been muted. The other interesting point is the Australian yield curve which shows that yields at the short end are actually lower at the end of the year than they were at the start of the year. Australia managed to avoid recession after the GFC, a beneficiary of the massive stimulus undertaken by China and the ensuing demand for Australia’s hard commodities. However, as China’s economy subsequently slowed and commodity prices fell, the recession finally caught up with Australia and the Official Cash Rate (OCR) has been slashed in 2013, hence short-term rates are lower than where they started the year.

As 31 December 2013 Financial Statements are completed there will be many CFOs relieved to see the turning of the tide in regards to the revaluation of borrower derivatives.

2012 to 2013 yield curve movements

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions. http://bit.ly/1at7pk0

It’s risk management stupid

The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.

The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?

Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.

Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.

Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.

As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.

Interpreting Possible Fed Taper Scenarios

The US economy slowed in the months since the idea of QE3 tapering was first floated. In light of recent price developments, we examine the case: to taper or not to taper?

The Federal Reserve’s balance sheet has jumped by over $3 trillion since the global financial crisis erupted in 2008. QE1, the first large scale asset purchase (LSAP) program was bold: it mind as well as saved the entire global economy. Just how bold? Fed Chairman Ben Bernanke won TIME Magazine’s coveted “Person of the Year” anointment in 2009.

QE2 was similarly successful, but not met without its critiques. A $600 billion bond-buying program was nothing to shake a stick at; it propelled global equity markets higher from November 2010 through June 2011, before the Euro-Zone crisis decided to wake up and the U.S. lost its ‘AAA’ rating at Standard & Poor’s for continued political brinkmanship (which continues today).

QE3 has proven to be the least effective and most controversial easing plan to date, more so than the even bolder measures taken in Japan by the government and the Bank of Japan, collectively known as ‘Abenomics.’ When the Fed announced QE3 in September 2012, market pundits were convinced that U.S. yields would plummet and the U.S. Dollar would be thrashed – more of the same of QE1 and QE2. QE3 was dubbed “QE-infinity” given its open-ended nature. But instead, with the U.S. economy improving, and yields shooting up in favor of a stronger U.S. Dollar, there’s growing support inside and outside of the Fed for a reduction in QE3.

There are several reasons to taper and not to taper, and they will be weighed by the Fed at its future meetings as the central bank eventually winds down its purchases. On the positive side, the fiscal drag thanks to the budget sequestration has proven much less daunting than previously forecasted, and the U.S. fiscal deficit is falling at its fastest rate in over 50 years. The U.S. unemployment rate is now at 7.0%, as low as it’s been since 2008.

The negatives are evident as well. Labor market growth has slowed in recent months, and Nonfarm Payrolls figures have eroded through midyear. Consumption has started to fall, and that may be a symptom of recently higher interest rates; higher borrowing costs reduce disposable income, and with wage growth dead, it is likely that higher rates remain a negative influence on the U.S. economy. These consumption fears have manifested in soft inflation figures throughout 2013.

Whether or not the Fed tapers QE3 will be determined shortly, but given the meteoric rise in U.S. yields the past several months, any outcome – even a $15B taper – could provoke a pullback. Consider that within the past six months, the U.S. Treasury 10-year note yield was as low as 1.631% on May 2, and had risen to as high as 2.979% on September 5 – over a 40% increase.

We thus suggest: if the Fed decides only on a modest taper $0B-10B/month, there is a significant scope for U.S. yields to pullback. Between $10B-20B/month, recent downside pressures in emerging markets and upside pressures in U.S. yields will remain; these will continue to manifest into further emerging market FX and high yielding FX weakness.

Chinese Growth Slows, Hurting Regional Trade Partners

Our last update on the Chinese economy expressed concerns over the future path of growth. The transition to the free market from a centrally-planned state has proven to be difficult as the government fights financial and political corruption, a growing middle class, and international pressure to liberalize its currency, the Yuan.

Chinese growth is slowing, but there’s nothing that the once frequently interventionist government is going to do about it. In part, growth slowed alongside lending activity, as the People’s Bank of China has maintained tighter monetary conditions for two main reasons: as it attempts to weed out illegal and corrupt banking practices that take place off companies’ balance sheets, “shadow banking.”

If only to consider the scope of this problem, on June, the interbank lending rate, overnight SHIBOR (local equivalent to LIBOR), rose by an astounding 578-basis points to 13.4%. In comparison, the 1-week SHIBOR rate rose by 292-bps to 11.0%; this inversion of the SHIBOR curve is a strong indication of extremely tight credit conditions. Typically, yield curves invert when liquidity is a problem; the fall of 2008 was plagued by this issue in the United States in particular.

In our last post regarding Chinese growth, we said, in a ‘tongue-in-cheek’ manner, that “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.”

Were those views ever vindicated: in June, the Chinese government said that so-called arbitrage transactions distorted trade figures in a manner favorable to stronger growth. From Bloomberg: “The transactions “resulted in abnormal growth in mainland-Hong Kong trade for a few months” since the fourth quarter, Shen Danyang, a Commerce Ministry spokesman, said at a monthly briefing today in Beijing. “Even if these arbitrage trades are not necessarily illegal, they are not fully compliant with regulations. That’s why the government has been concerned about this.”

As the government faces these issues and more on the way to opening up the Chinese economy even further, it’s evident that any new policies will be geared towards a more regulated, transparent economy. Accordingly, to prevent fueling a housing bubble (which is a concern now), the government is unlikely to implement further fiscal stimulus in the near-term. This has and will leave the economy weak in 2013:

China GDP

As long as Chinese growth remains in a rut, global trade will remain dampened and hopes for broader global recovery will be teeter. An ongoing concern for Australian policymakers, signs of slowing Chinese growth continue to weigh on the economy, where the Reserve Bank of Australia cut the main rate to a record low 2.50% in August.

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 remain under pressure in the interim.

European Growth Rebounds and Bolsters Euro Turnaround

This post will discuss the improving economic conditions that have started to emerge from the Euro-Zone. Policymakers have a difficult task of balancing a diverse regional economy marked by declining rates of production, consumption, inflation, and overall growth, all of which are exacerbated by a recently-strong Euro.

The Euro-Zone has backed away from the brink of collapse – for now. The recession that’s gripped the region since the 2Q’12 appears to be abating, with the contraction appeared to having bottomed in the first half of 2013.

Euro 10 yr bond spreads

The rebound, in its entirety, can be attributed to the European Central Bank’s efforts to reduce financial risk in the region in the summer of 2012, when it announced its outright monetary transactions (OMT) program, essentially an unlimited safety net for Euro-Zone countries facing high borrowing costs in trading markets.

Euro GDP

The Euro, with the tail-risk premium of a break up very-much diminished, has sparkled amid the turn in growth prospects. After bottoming just above $1.2000 against the US Dollar in July 2012, the Euro has spent much of 2013 trading above $1.3000, trading as high as $1.3832 on October 25. The resiliency of the Euro is commendable two-fold: first, not only due to warding off breakup threats; but also because the US yields have risen sharply thanks to the Fed’s upcoming reduction in QE3.

Euro PMI

The rebound in regional economic activity, of course underpinned by stability in peripheral bond markets, may continue through the remainder of 2013 and into early-2014, if incoming PMI data is accurate. In fact, the last time we discussed the Euro-Zone crisis, manufacturing and services PMI figures from across the region were struggling below 50, the demarcation between growth and contraction.

In February 2012, only German PMI Services showed growth, while the other seven gauges tracked (manufacturing and services for Germany, the Euro-Zone, France, and Italy, each) were contracting. Indeed, our last commentary was near the “bottom”; and now five of the eight PMI readings are in growth territory (see chart above). Further sustained signs of economic progress in the region will only further serve as a bullish catalyst for the Euro.

Going forward, political risk is what could undermine the Euro. Corruption in Spain and Italy threatens the governments (the latter especially), while record or near-record high unemployment rates across the Euro-Zone will only serve as a constant reminder as to how far the region needs to go before “recovery” can be declared. Depending on what the Fed does over the 4Q’13 – will it taper? by how much? in what increments? – the EURUSD is positioned for the time being to finish the year above $1.3300 so long as political pressures remain subdued and further signs of European ‘green shoots’ emerge.

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.