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.

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.




How Will the Aussie and the Kiwi be affected by ‘Slowing’ Chinese Growth?

This post will discuss Chinese growth, the recent decline in base metals’ prices, and the outlook for the Australian and New Zealand Dollars.

The story of China’s “hard landing” is an easy sell: excess liquidity in the Chinese financial system, thanks to the People Bank of China’s massive expansionary monetary policy over the past few years, will stoke inflation; and then the PBoC will be forced to tighten policy too quickly, ensuring what is known as a liquidity trap, choking off growth far too rapidly.

But the naysayers have been proven wrong thus far. The 4Q’12 annualized Chinese GDP figure came in at +7.9% from 7.6% in the 3Q’12, and growth is expected to have a floor near +7.5%, according to estimates provided to Bloomberg News back in December. As always, we look to the PMI Manufacturing index, as well as base metals’ prices (the literal building blocks of society come from base metals), as forward indicator of Chinese growth prospects. The signs aren’t welcoming going forward.

Chinese PMI-manufacturing and iron ore spot

Iron Ore is a strong indicator of future growth prospects because it is required in the process to make steel; and steel, of course, is the preferred material to construct larger buildings, making it a popular resource in emerging market economies like China. Over the past several months, Iron Ore prices rallied quickly; but in February, prices have started to pull back as the Chinese PMI Manufacturing index has eased. Not only does this mean China could see slower growth going into mid-2013, but so too could Australia and New Zealand, as two regional economies for which China is their number one trading partner.


On their own, Australia and New Zealand are very different economies and countries. But in the broad context of global finance, their currencies are very alike – both are considered to be high beta commodity currencies, given the higher interest rates offered by their respective central banks. Considering where the market is pricing in rate expectations for the Australian Dollar over the next 12-months, it appears that the Australian Dollar is below fair value; on the other hand, the New Zealand Dollar is trading slightly rich relative to its interest rate expectations.

In the context of Chinese growth, Australia is more likely to be directly affected than New Zealand, so Iron Ore, Australia’s top export, serves as a strong proxy for growth hopes for China. At this point in time, given the signal in not just Iron Ore, but Copper as well (which has fallen back very sharply the past several weeks), it appears that the Australian and New Zealand Dollars could be poised for continued weakness throughout the 1H’13, before turning around and strengthening in the 2H’13, especially against the European currencies. The AUDUSD could decline into 0.9800 before rebounding back towards 1.0600, while the NZDUSD could fall towards 0.8000 before a move back to recent highs near 0.8500.

Regional Politics in Europe Awakes a Sleeping Giant

This post will discuss how revived regional political tensions have provoked the reemergence of the sovereign debt crisis, accelerating the timeline for significant Euro weakness from the 2H’13 into the end of the 1Q’13. We also explain why any calmness in markets will be as a result of the European Central Bank, and nothing more.

As we said in the first post in this series, coming into 2013, peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency into February 1. But the journey from $1.2041 versus the U.S. Dollar on July 24 to $1.3710 on February 1 was not an easy one; at many points it appeared like the European Central Bank-induced rally was going to fall apart. This go-around, it may be time.

Post 7a image

With each tumble in the EURUSD in 4Q’12, there was an ensuing rally. But why not; the Federal Reserve had begun its QE3 program and the political situations from Greece to Spain were much calmer than they had been back in July. Yet everyone was very aware that the economics of the region (discussed last post) were remaining quite sour and in most cases, getting worse. Clearly, just as was the case with the rally in the S&P 500, there are other forces in play here driving confidence in the Euro, because a regional growth rate at its weakest point in the past five years is no reason to be bullish.


In order to buy governments time and bring down sovereign borrowing costs, ECB President Mario Draghi fulfilled his late-July pledge to do “whatever it takes” to save the Euro by pledging a liquidity program known as the OMTs, or Outright Monetary Transactions, which would effectively place a ceiling over Italian and Spanish yields for an unlimited amount of time, so long as budget consolidation was taking place.

Initially, similar to the impact that the Federal Reserve’s QE has had on the U.S. Dollar, the expanding ECB balance sheet size in early-2012 led to a sharp depreciation in the value of the Euro. But with bond yields tethered down and no additional liquidity injections required, the ECB was able to reverse the its balance sheet expansion by late-2012, and reduce its size in the beginning of 2013. While this initially led Euro strength over the past several months, sufficient evidence has gathered that the crisis may have been stirred.

The Italian elections that took place at the end of February emphasized how fragile the overall situation is in Europe: voters are becoming angry with their leaders, feeling as if supranational or even international powers are dictating policy. This is fitting, given the governments present in Greece, [especially] Italy, and Spain presently. Pandora’s Box has now been opened: 55% of the Italian electorate voted for the anti-austerity candidates, meaning that the Italian economic picture could worsen dramatically quickly once more, if investors lose faith in the bond market.

Greece and Spain are no “picnics” either. The Greek government remains highly unpopular and will likely head back to elections once German Chancellor Angela Merkel retains her chancellorship in the September German elections, while the Spanish government faces corruption charges and still puts off the necessary budget reforms desired by the core Euro-zone countries. We find there little reason to be bullish on the Euro, given the significant backdrop of European growth and political concerns, and wouldn’t be surprised in the slightest to see the EURUSD trade under 1.3000 for a sustained time (>3 months) in 2013.

This series of eight posts will focus on the major themes affecting currency markets. The eighth and last post in this series will review Chinese growth, performance of base metals, and forecasts for the Australian and New Zealand Dollars for 2013.