Year-end Financial Instrument Check List

30 June marks the financial year-end for many Australian and New Zealand public and private companies, as well as Councils. With an ever increasing compliance burden, we have put together a practical check list for those entities that have exposure to financial instruments such as FX forwards, FX options and interest rate swaps. Those familiar with the international accounting standards understand the minefield that they are, with pages upon pages of text. We have boiled them down to five simple, practical and fundamental items.

 

Fair value (IFRS 13 / AASB 13)

IFRS 13 clearly states that valuations need to be an independent “exit price” for the transaction. It is hard to argue that a valuation from one of the counterparties to the transaction (i.e. the bank), constitutes an independent valuation, however, there are still many companies that rely on their bank for this information. Such reliance on the bank is understandable when the auditor accepts this approach, although we are seeing a much bigger push by the audit community to challenge companies on the lack of independence of a bank valuation given the bank is counterparty and valuer of the financial instrument. Historically there have been few economic alternatives to bank valuations, that is no longer a valid argument.

 

CVA/DVA (IFRS 13 / AASB 13)

The most recent compliance requirement for companies using financial instruments is the adjustment to fair value for credit. IFRS 13 requires a Credit Value Adjustment (CVA) or Debit Value Adjustment (DVA) to all financial instruments. Financial institutions have been credit adjusting their own positions for years, however, the requirement has filtered down so that all parties to financial instrument transactions must calculate and apply a credit adjustment. There is a strong argument that it is overkill for companies using financial instruments to hedge their foreign exchange cashflows (payments/receipts) or debt using plain vanilla instruments to have to make CVA/DVA adjustments. There is little added-value to the company, there is a cost to calculate the adjustment and the number is often immaterial (still have to calculate the number to determine its immateriality, however). It is different if you are trading financial instruments or are using credit hungry instruments such as cross-currency interest rate swaps but auditors, as prescribed by the accounting standards, are (or should be) forcing all financial instruments to be adjusted by CVA/DVA. There is a multitude of approaches to calculating CVA/DVA from the complex (potential future exposure method) to the simple (current exposure method). For those using plain vanilla instruments such as FX forwards or interest rate swaps then a simple methodology is appropriate. It is worth noting that the movement in both FX rates and interest rates over the last 12 months means valuations have moved significantly over the last 12 months which results in higher, more material CVA/DVA adjustments.

 

Sensitivity analysis (IFRS 7)

As part of the notes to the accounts under IFRS 7 there is a requirement to include a sensitivity analysis for financial instruments. This is a “what if” scenario that requires the re-calculation of fair value if the underlying market data is flexed. Often a +/-10% movement in the spot rate is used for FX instruments and a +/-100bp parallel shift in the yield curve for interest rate instruments. In theory there should be some sense check applied to the probability of the movement occurring i.e. if interest rates are close to zero then there is a low probability of a -100 basis point adjustment in the curve. We see little evidence of this in practice.

 

Hedge effectiveness testing (IAS 39 / IFRS 9 / AASB 9)

One of the biggest headaches at year-end is for those hedge accounting. Hedge accounting was introduced for practical reasons – remove noisy P&L volatility from unrealised gains/losses on financial instruments and put these adjustments on the balance sheet instead. In the early days of hedge accounting the approach was complicated and expensive. As auditors and accountants understanding of hedge accounting has developed over time, the process of hedge accounting has become much less complex. The most important aspect is the documentation. The effectiveness testing aspect of hedge accounting is fairly straightforward, particularly when utilising a treasury management system. The replacement of IAS 39 by IFRS 9 (effective 1 Jan 2018) will make hedge accounting a little easier with the removal of the 80-125% bright line and removal of the requirement to split option valuations between time and intrinsic value.

 

Time versus intrinsic (IAS 39)

Until IFRS 9 is effective (Jan 2018), companies hedge accounting for FX options (whether outright purchased options or in a collar relationship) must split the value of an option into its time and intrinsic components. The intrinsic value of an FX option is the difference between the prevailing market forward rate for the expiry of the FX option versus the strike price. The time value of an FX option is the difference between the overall FX option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the FX option. The longer the time to expiry, the higher the time value as there is a greater probability of the FX option being exercised. The intrinsic value goes to the balance sheet whilst the time value goes to P&L. Splitting time and intrinsic value is not too easy to do on the back of an envelope/spreadsheet, rather it is something that lends itself to be derived from a system.

 

Summary

Many companies try to complete the necessary compliance through using spreadsheets and bank valuations which is not only poor practice (valuations should be independent) but also error prone and time consuming. There are low cost systems available that can streamline, simplify and improve the ever increasing burden of year-end reporting requirements.

This article should not be taken as accounting advice but rather a practical guide and check list.

Digital disruption in the Treasury Management System space

There is a digital revolution going on in the treasury management system space, not that you would necessarily know.  For many there is still a stark choice – over-priced, over-complex and over-engineered treasury systems or good old Excel spreadsheets. But the world is changing and as with all things technology, it is happening at a rapid pace.

Globally, larger organisations are well catered for as far as treasury management systems are concerned, and in fact it is a crowded and mature market. The PwC Global Treasury Survey of 2014 showed that 80% of those companies surveyed were using some type of treasury management system. However, as with big ERP systems, the issue for the providers of large, expensive treasury systems is how to offer a cost-effective alternative to the massive SME market without detrimentally affecting their existing market. The challenge is to offer a slimmed down treasury management system without compromising the huge premium that they currently charge.

So where is the competition for these large, expensive systems coming from? The answer is the cloud app revolution which is sweeping the world. Platforms are being developed that aggregate a whole bunch of cloud apps, both financial and non-financial. The really clever bit is the integration of these different apps and bringing it all together through a variety of widgets and dashboards to give a complete, and often unique, view of a company’s position. It’s like a Fitbit for business.

Not only are these cloud app aggregators bringing leading edge technology to the SME market but they are doing so for small monthly fees. The apps cross the spectrum of business tools such as accounting systems, CRMs, social media tools and now treasury management systems. All of this for a few hundred dollars a month.

In the on-line accounting world, Xero is leading the charge in the digital disruption revolution with its New Zealand developed, $50 per month product. Treasury systems will need to follow suit with a much cheaper solution.

By leveraging cloud technology, treasury systems can be implemented for costs palatable to the underserviced SME market. There is an enormous amount of importers and exporters hedging their foreign cashflows with forward exchange contracts and possibly FX options. These companies probably aren’t hedge accounting, even if they are reporting under IFRS, but the impact of exchange rate movements is vitally important to their bottom line.

SMEs require the ability to record, report and value their transactions but just as importantly they want access to tools to help them make better hedging decisions. This is not too different from larger companies except SMEs are mostly using plain vanilla instruments. For a small monthly fee SMEs can benefit from a treasury management system with basic functionality, which integrates perfectly with other cloud based apps. So as we have seen with cloud based accounting systems, the power that was once reserved for large organisations can be put in the hands of a much larger group for a fraction of the cost.

Whether the current treasury management system providers have a solution for the SME market remains to be seen. It maybe that they do not care for this part of the market, however there are parallels with the large and expensive ERP systems which have successfully moved into the mid-market space and are now looking at the next tier down. The conundrum for treasury management system providers will be that SMEs will desire the core functionality of a larger system but without the price tag. The digital revolution for treasury management systems may only be in its infancy but it is set to have major ramifications regardless of the size of organisation.

First published on Treasury Insider (www.treasuryinsider.com)

Demo HedgebookPro for Free

Hedgebook is pleased to announce the launch of the free demo version of its flagship product HedgebookPro.

Potential users now have the ability to try before they buy. Simply go to the HedgebookPro website (www.hedgebookpro.com) and click on the big red button (it’s hard to miss). Fill in your details and we will send an email link of your login details so you can have a decent gander at the full functionality of HedgebookPro.

If you like what you see we can set you up with your own account by emailing us at enquire@hedgebook.co.nz. It’s as simple as that.

Give it a try and join the legion of users accessing the most cost-effective little treasury system known to man.

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.

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.

IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.

Scope for Recovery by Australian Dollar Limited as Labor Suffers

The Reserve Bank of Australia cut its key benchmark interest rate to a record low 2.50% earlier this year, highlighting the central bank’s concerns over the sensitivity of the Australian economy to turmoil in emerging markets.

When discussing Australia at the turn of the year, we suggested that: “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.”

These concerns were well-informed, as the Australian labor market has only deteriorated over the course of the year, forcing the Reserve Bank of Australia to cut its main interest rate to a record low of 2.50% at its August policy meeting. This is a significant step lower from the 4.75% rate employed as recently as November 2011; an aggressive rate cut cycle the RBA has employed, indeed.

Nevertheless, it’s evident that concerns surrounding Australia will continue. The country’s most important sector, mining, continues to show signs of slowdown, and government advisors have reluctantly admitted that the global commodity supercycle – driven by rapidly growing emerging markets – may be finished.

We continue to believe that the changing economic climate of Australia will play a negative influence on the Australian Dollar. The labor market remains a primary concern, and has proven to be a major negative influence on the Australian Dollar in recent months:

AUDUSD_unemployment

Over the past two-plus years, after the AUDUSD peak near $1.1100 in the summer of 2011, the RBA’s aggressive easing cycle, in part to help soothe fears over the labor distress, has driven the AUDUSD down to its lowest exchange rate since September 2010, below $0.9000 in August.

Further pressure on the Australian labor market, and thus the Australian Dollar, seems likely. Whereas the AUDUSD was quite stable near $1.0500 for several months while labor markets deteriorated, it’s clear that reality has set in. Despite several rate cuts since November 2011, Australia’s unemployment rate has increased from 4.9% in April 2011 to 5.8% in August 2013, the highest rate since August 2009.

Scope for recovery in the labor market is limited at best as long as the commodity cycle slowdown persists. Data compiled by the RBA in August showed that base metals prices, perhaps most indicative of economic strength in the mining sector, sunk to their lowest level since late-2009 by midyear, an ominous sign considering the time before prices had reached that level it was on the way lower by another 30% amid the global financial crisis of 2008.

RBA CPI

Base metals prices continue to be the guiding light for Australia – and should they remain subdued going forward, we suspect that dovish guidance will remain in place at the RBA, serving as a consistent, bearish influence on the Aussie for the remainder of 2013.

Steel, iron ore and coking coal

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.

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.