Recent events in Mexico have prompted some to liken the current situation to the 1994 Tequila Crisis which ended with hyper-inflation, a collapse of the Mexican Peso, emergency loans from the US to the Mexican Government, and a deep economic contraction. The Financial Times even ran a story saying that the US, Mexico and the IMF should pre-negotiate terms of an assistance package in case it is needed. (Though to be fair, they admitted such a case is highly unlikely) Many of these voices come from the fact that two factors which proceeded the '94 crisis are superficially present today. Namely, '94 was a year of political instability in Mexico and the beginning of a monetary tightening cycle in the US. It is true that street protests are happening in Mexico over the murder of 43 students in Igula, Mexico, and the Fed will probably hike rates next year. However, noting a few similarities and concluding that Mexico is on the brink is shoddy analysis. Mexico has worked had for twenty years to learn from the '94 crisis and shore up its defenses so that it can absorb both internal and external shocks.
In 1994, Mexico was on a fixed exchange rate regime. Thus, any exit of dollars out of the country would force the Bank of Mexico to sell dollar reserves to defend the peg. This made it extremely attractive for speculators to attempt to break the peso on the hint of any sort of trouble. When a presidential candidate was assassinated in '94, and the Fed was on the verge of raising interest rates, which would increase the incentive for US investors to repatriate funds from abroad, a perfect storm ensued and the rest in history. The pre-election spending spree by the Salinas administration also caused some to worry about the government's fiscal position, and began to scare off international investors.
Today the Bank of Mexico has over 190 billion USD in reserves and is committed to flexible exchange rate. It has the most liquid capital markets among the EM countries, with government yield curve going out to 30 years. Government finances are stable and the Mexican Government has no problem funding itself exclusively on the MXN denominated local market. Thus unlike '94, it does not depend on external financing, a significant fact given that international investors are more easily spooked by bad news. Mexico also has a 71 billion dollar flexible credit line(which was renewed this month) with the IMF which serves as a further buffer.
Central bank independence, which was an initial reform implemented in the wake of the '94 crisis, has served Mexico well. Since then, inflation targeting from the Bank of Mexico has delivered price stability as well as a strong, strictly regulated and well capitalized banking sector. 2014 is not a replay of 1994.
The selloff in recent weeks, and especially since Thanksgiving, has been the product of many factors. First, oil prices have plunged since OPEC announced that it would maintain production despite the current oversupply. This has caused some to worry about the Mexican economy, given that Mexico is major oil producer. However, it is important to note that today crude oil accounts for only 10 percent of Mexican exports, as compared to over fifty percent in '94. Mexico has done a remarkable job diversifying its industrial base. A report release on Friday showed that manufacturing output increased by 3.9 percent. Construction, which had been in a terrible slump since mid 2012, surged 5.4 percent, the fourth consecutive month of gains after nearly 18 months of contraction. In sum, both internal and external demand appear to be rebounding. Yes, Mexico will earn less from its oil, but that is but a small component of a highly diversified economy.
Secondly, a broader EM sell off has occurred on prospect of tighter US monetary policy. This was exacerbated by the Dec 5th non-farm payrolls report which beat expectations by over 100,000 jobs. Unlike prior episodes, Mexico was unable to escape as the USD strengthened broadly.
Third, the MXN got hit again by risk-off sentiment last week as concerns over global growth pushed bond yields down. The usual safe haven suspects rallied, (CHF,JPY) and EM currencies were on the back foot again regardless of idiosyncratic strengths or weaknesses. It was just more panic selling.
Fourth, the Mexican peso is the most liquid of the EM currencies and is the 8th most traded currency in the world. Many speculators have made large bets against the peso as a 'proxy' in order to profit from the broader EM selloff. This exaggerates the Peso's downward moves at times. Unfortunately, futures and options contracts do not exist for many other EM currencies, or are illiquid. This has encouraged many speculators to simply bet against the peso instead of betting against EM assets more broadly. This explains some extreme positioning the options and futures markets, with speculators amassing a record net short position against the peso.
Fifth, it is crucial to note that the Peso depreciation does not appear to be the result of capital flight. Indeed, participation by foreigners in the local bond markets is steady at 37 percent. More evidence that the trouble is coming from offshore speculators in the futures and options markets.
I will admit it. The last few weeks have been extremely humbling to say the least. The extreme positioning has caused a precipitous drop in the MXN. Oil linked currencies, such as CAD, NOK, and RUB have also sold off broadly as oil plunged The MXN, which in 2013 was able to resist the steep declines seen in the likes of ZAR, TRY, or BRL has had no such luck in Q4 of 2014. However, the firm rejection of the 15 level for USD/MXN may be a sign the there is finally a marginal bidder for the beleaguered peso. One strong piece of evidence in support of this view is that despite oil's 4 percent drop on Friday, the Peso held on to most of its gains, and was actually able to close the trading day up after falling as far as 14.94 to the dollar. While further long dollar positioning ahead of next week's FOMC meeting may crimp the Peso style, I expect the MXN recover broadly in the coming months. Q1 of 2015 should see a test of the 14 handle, and to end Q1 between 14 and 14.2. I expect to see USD/MXN ending 2015 between 13.50 and 14.
Saturday, December 13, 2014
Tuesday, October 28, 2014
The Return of FX Fusion
After several significant life changes (for the better!) I am ready to start what I hope will be a steady stream of FX commentary. Lot's of exciting things have happened in the foreign exchange and capital markets. I face the future, both in a person and professional sense, with more confidence than ever. So without further ado, let's get to work!
The National Bank of Hungary issued a surprisingly upbeat assessment of internal economic conditions its statement which accompanied its interest rate decision. The base MNB policy rate, or the rate paid on HUF deposited for two weeks at the Central Bank, was left unchanged at 2.10 percent. The bank referenced relatively robust growth when compared with the rest of Europe, noting growth rates of 3.7 and 3.9 percent in the first and second quarters respectively. The Bank expects this trend to continue. Of particular note is the gradual recovery of the consumer sector, as well as the large public investments in infrastructure. Hungary also continues to benefit from EU development funds intended to bring living standards in less developed member States. Nonetheless, these funds only amount to 0.3 to 0.4 percent of GDP.
On the inflation front, the Bank believes the low inflation environment in the rest of Europe, as well as falling commodity prices, are responsible to historically low Hungarian inflation despite a relatively strong domestic economy. The Bank also highlighted the Funding for Growth Scheme, which is similar to the BoE funding for lending program. The Bank also noted the reduction of foreign debt, and the re-domination of EUR and CHF loans into HUF, aided both by the initiatives of the central government and the FGS. Both these developments have reduced Hungary's once problematic external vulnerabilities.
On FX, the HUF remains a carry trade candidate, but only against the EUR or CHF. Several factors however should caution investors from jumping in with both feet. Most importantly, in times of Eurozone stress, the currencies of developing European economies have tended to depreciate against EUR and CHF even despite the factor that these countries are presumably somewhat better insulated from Eurozone troubles precisely because they have opted to retain monetary sovereignty. Panic selling of risky assets, especially those with exposure to Europe, is the likely explanation. In other words, it seems unlikely that the market will differentiate between the weaker and stronger EM currencies in the event of adverse shocks. Secondly, HUF only yields 2.1 percent, one of the lowest rates in the entire EM space. Third, European weakness will likely be a major theme going forward, and this trade is essentially neutral Europe. Selling EUR or CHF against KRW, MXN or even COP will both earn more carry, but also allow investors to capture capital appreciation derived from stronger growth of the rest of the world vis a vis Europe.
The National Bank of Hungary issued a surprisingly upbeat assessment of internal economic conditions its statement which accompanied its interest rate decision. The base MNB policy rate, or the rate paid on HUF deposited for two weeks at the Central Bank, was left unchanged at 2.10 percent. The bank referenced relatively robust growth when compared with the rest of Europe, noting growth rates of 3.7 and 3.9 percent in the first and second quarters respectively. The Bank expects this trend to continue. Of particular note is the gradual recovery of the consumer sector, as well as the large public investments in infrastructure. Hungary also continues to benefit from EU development funds intended to bring living standards in less developed member States. Nonetheless, these funds only amount to 0.3 to 0.4 percent of GDP.
On the inflation front, the Bank believes the low inflation environment in the rest of Europe, as well as falling commodity prices, are responsible to historically low Hungarian inflation despite a relatively strong domestic economy. The Bank also highlighted the Funding for Growth Scheme, which is similar to the BoE funding for lending program. The Bank also noted the reduction of foreign debt, and the re-domination of EUR and CHF loans into HUF, aided both by the initiatives of the central government and the FGS. Both these developments have reduced Hungary's once problematic external vulnerabilities.
On FX, the HUF remains a carry trade candidate, but only against the EUR or CHF. Several factors however should caution investors from jumping in with both feet. Most importantly, in times of Eurozone stress, the currencies of developing European economies have tended to depreciate against EUR and CHF even despite the factor that these countries are presumably somewhat better insulated from Eurozone troubles precisely because they have opted to retain monetary sovereignty. Panic selling of risky assets, especially those with exposure to Europe, is the likely explanation. In other words, it seems unlikely that the market will differentiate between the weaker and stronger EM currencies in the event of adverse shocks. Secondly, HUF only yields 2.1 percent, one of the lowest rates in the entire EM space. Third, European weakness will likely be a major theme going forward, and this trade is essentially neutral Europe. Selling EUR or CHF against KRW, MXN or even COP will both earn more carry, but also allow investors to capture capital appreciation derived from stronger growth of the rest of the world vis a vis Europe.
Tuesday, June 10, 2014
Commentary: Mexico's Surprise Cut Casts Uncertainty on FX Outlook.
Mexico's aggressive fifty basis point cut last Friday caught the market off guard and sent the peso down nearly 900 points to 12.90. The Peso has slipped further 1500 points to levels around 13.05 against the greenback as of Tuesday afternoon. Putting this further slide in context, the dollar has performed well over the past several days rising substantially against other majors in the wake of Friday's positive jobs numbers. However, it also worth noting that in the hours between the release and Mexico's rate cut announcement, the Peso outperformed with USD/MXN sliding to 12.81. This signals that the market is still bullish the Peso in the sense that good data from the US is not causing investors to fret over potential tightening from the Fed. Rather, what's good for the US is probably still good for Mexico, and thus increases the attractiveness of Mexican assets.
While two day chart for USD/MXN looks very similar to USD/ZAR or USD/PLN, there's no denying that the Peso has substantially underperformed since Friday as compared to other Latin American currencies. Brazil's Real led the charge with USD/BRL down nearly about 2 percent since Friday. USD/COP and USD/PEN have risen a bit since Friday, but remain largely unchanged. USD/CLP has also tread water over the past two trading days.
The longterm outlook for the MXN has just become much less certain. Mexico is still an attractive place for foreign capital. The latest auction of short term government bonds was well attended, with 182 day Cetes achieving a bid to cover ratio of just under 4-1. The bid to cover on twenty year placement held on the same day was 4.2. It short, it still looks as though the market is still hungry for Peso denominated debt, a nice silver lining.
While central bank admonished the market that further rate cuts were not on the horizon, we've seen similar language before, specifically when Mexico started on the current easing cycle in early 2013. In general, despite a solid longterm story, the central bank seems unsatisfied while mediocre growth in the first quarter. (Though again, its important to keep in mind that Mexico's largest trading partner, the US, shrunk in Q1) Indeed, the Peso's fate is intimately tied to the US outlook and Mexico's ability to deliver strong growth. From the energy sector to education, there's a lot of progress which has been made. However, these moves have yet to result in better economic performance, and investors may lose patience.
Realistically, these reforms will take years if not decades to boost growth, which the possible exception of the dismantling of the Pemex monopoly which may allow for new investments as soon as 2016. The short term growth outlook will depend heavily of the central government's ability to bring new spending projects online. The fiscal authorities have fully reversed their premature tightening that began with the new presidential administration in 2013. However, disbursing funds for new projects has been slow, resulting in lower than projected deficits and thus less stimulus that had been planned. This red tape has undoubtedly hampered growth.
Technically, the short-term outlook probably hinges on the Peso ability to remain above its 2013 lows against the dollar. A quiet week with little movement would do wonders for the Peso. Ideally, it would settle into a new range, maybe around 13.00 to 13.1, making it attractive to carry traders.
In sum, the Banco de México has certainly gotten what it wanted. It has shaken up the markets and grabbed investor attention. Let's hope this dynamism reaches the real economy.
While two day chart for USD/MXN looks very similar to USD/ZAR or USD/PLN, there's no denying that the Peso has substantially underperformed since Friday as compared to other Latin American currencies. Brazil's Real led the charge with USD/BRL down nearly about 2 percent since Friday. USD/COP and USD/PEN have risen a bit since Friday, but remain largely unchanged. USD/CLP has also tread water over the past two trading days.
The longterm outlook for the MXN has just become much less certain. Mexico is still an attractive place for foreign capital. The latest auction of short term government bonds was well attended, with 182 day Cetes achieving a bid to cover ratio of just under 4-1. The bid to cover on twenty year placement held on the same day was 4.2. It short, it still looks as though the market is still hungry for Peso denominated debt, a nice silver lining.
While central bank admonished the market that further rate cuts were not on the horizon, we've seen similar language before, specifically when Mexico started on the current easing cycle in early 2013. In general, despite a solid longterm story, the central bank seems unsatisfied while mediocre growth in the first quarter. (Though again, its important to keep in mind that Mexico's largest trading partner, the US, shrunk in Q1) Indeed, the Peso's fate is intimately tied to the US outlook and Mexico's ability to deliver strong growth. From the energy sector to education, there's a lot of progress which has been made. However, these moves have yet to result in better economic performance, and investors may lose patience.
Realistically, these reforms will take years if not decades to boost growth, which the possible exception of the dismantling of the Pemex monopoly which may allow for new investments as soon as 2016. The short term growth outlook will depend heavily of the central government's ability to bring new spending projects online. The fiscal authorities have fully reversed their premature tightening that began with the new presidential administration in 2013. However, disbursing funds for new projects has been slow, resulting in lower than projected deficits and thus less stimulus that had been planned. This red tape has undoubtedly hampered growth.
Technically, the short-term outlook probably hinges on the Peso ability to remain above its 2013 lows against the dollar. A quiet week with little movement would do wonders for the Peso. Ideally, it would settle into a new range, maybe around 13.00 to 13.1, making it attractive to carry traders.
In sum, the Banco de México has certainly gotten what it wanted. It has shaken up the markets and grabbed investor attention. Let's hope this dynamism reaches the real economy.
Monday, March 3, 2014
Commentary: Ukraine Crisis Highlights Relative Resilency of EMs
Risk aversion is rearing is ugly head today, with the crisis in the Ukraine as stocks dipped worldwide. On FX, the USD and JPY are the big winners, with EUR, CHF and GBP all down about 40 pips versus the greenback. EM currencies, even those with negligible economy ties to the Russian Federation, have taken on the chin, though again top tier EMs have outperformed relative to there sluggish counterparts. Since Sunday night, MXN has slid about 800 pips against the USD, or 0.6 percent. The South Korean Won has also outperformed. Remarkably, KRW has managed to hold on to most of its gains from last week and has remained steady at 1070-1 to the dollar.
Other EMs have fared much worse. South Africa's Rand has fallen nearly 1500 pips in the past 18 hours, or 1.6 percent. LatinAM currencies have also performed poorly. Over the same period Brazil's Real has fallen a little less than one percent against the dollar.
Poland's Zloty has taken the brunt of the sell off, plunging 2.11 percent today against the dollar. Poland's economic ties to Russia are small but substantial. It sells 5.7 percent of its exports to the Russian Federation. Poland, a client state of the Former Soviet Union for nearly 60 years may also face instability at home if the crisis intensifies. More likely however is that an aggressive Russia may deter Western FDI into former eastern bloc countries.
In sum, I do not expect the events in the Ukraine to affect global markets much in the long term. EM currencies will rally sharply should the crisis get resolved, or even if things just die down. On local eastern European currencies, and the RUB itself, the instability may deter foreign investment, which would be FX negative. On the other hand, I don't see Russian tanks rolling into Budapest or Warsaw anytime soon.
Other EMs have fared much worse. South Africa's Rand has fallen nearly 1500 pips in the past 18 hours, or 1.6 percent. LatinAM currencies have also performed poorly. Over the same period Brazil's Real has fallen a little less than one percent against the dollar.
Poland's Zloty has taken the brunt of the sell off, plunging 2.11 percent today against the dollar. Poland's economic ties to Russia are small but substantial. It sells 5.7 percent of its exports to the Russian Federation. Poland, a client state of the Former Soviet Union for nearly 60 years may also face instability at home if the crisis intensifies. More likely however is that an aggressive Russia may deter Western FDI into former eastern bloc countries.
In sum, I do not expect the events in the Ukraine to affect global markets much in the long term. EM currencies will rally sharply should the crisis get resolved, or even if things just die down. On local eastern European currencies, and the RUB itself, the instability may deter foreign investment, which would be FX negative. On the other hand, I don't see Russian tanks rolling into Budapest or Warsaw anytime soon.
Friday, February 14, 2014
Commentary: Low Rates Don't Squeeze Seniors
It's a common refrain. Low interest rates may help the young and indebted, but deny interest income to seniors living off savings and social security. And like most untruths, it seems logical on the face of it. Cash balances at banks pay essentially zero, and most one year CDs yield a paltry 100 basis points. During Fed Chairman Yellen's testimony on Tuesday, many Congressman brought up seniors who supposedly have saved their money, done the right thing, and now have been hit hard by low rates. The classic response by the Fed is that while seniors may be deprived of interest income, their children and grandchildren are rewarded with better job prospects and more valuable homes. This may be true, but in reality any senior which really was saving before the financial crisis should have experienced the same windfalls other holders of fixed income assets did as rates fell through the floor.
Bond Price Explosion:
While low interest rates may make it hard for new savers to earn a solid returns if building a fixed income portfolio from scratch, falling interest rates are usually a windfall who those who have existing portfolios I assume this includes all those seniors out there that "did the right thing." A few back of the envelope calculations demonstrate this. Ten year US treasury yields were at five percent in late 2007, and then plunged to two percent in the depths of the financial crisis. The underlying price of these securities therefore increased substantially, that same ten year was worth over twenty percent more in 2009 than in 2007. Yields moved up again in 2010 as some signs of recovery sprung up, only to plunge again as the Fed gobbled up more long debt instruments as part of its so-called quantitative easing program. So again, since the financial crisis risk-free assets have been an excellent opportunity for financial gain. Many say seniors could not part with the liquidity and therefore could not purchase ten year bonds. Well, the equivalent two year notes which also yielded five percent in 2007 and then dropped to 0.3 percent in 2009 saw there values soar roughly 9 percent over the same period. Not a bad return considering that the Dow Jones Industrial Average would lose over fifty percent of its value during the financial crisis.
So far from being a lack of safe investment vehicles for seniors to invest in over the past five years, those who actually did invest in the very same safe securities they claim they want have made out like bandits.
Doing Alright:
Furthermore, compared to other Americans, seniors have fared much better in the financial crisis and the great recession. While poverty rates soared for younger Americans during the Great Recession from nine to fourteen percent, the rate of poverty actually declined for those aged 65 and older from 2008 to 2011. So much for seniors being forced into the poor house because of low interest rates. Other measures of well being also point toward seniors doing okay. As this figure shows, the median net worth of 35 to 44 year olds declined a whopping 58 percent from 2005 to 2010. Seniors on the other hand experienced only a 13 percent decline in median net worth over the same period. Those under thirty five, who have little savings are usually don't own homes, saw median net worth fall by 38 percent, while prime working-aged adults, or 45 to 64, year olds experienced a 25 percent decline. In sum, since, during, and after the Great Recession, seniors have experienced less poverty, and have suffered fewer losses in terms of net wealth than the average American.
Risky Business:
Unfortunately, what I susupect is really going on is that just like everyone else, seniors were heavily exposed to the stock market in 2007, not satisfied the five percent returns offered by government bonds or other safe instruments. When things went south, they followed everyone from the Norges Bank (which oversees Norway's 800 billion dollar sovereign wealth fund) to US hedge funds into government fixed income, but the glut of buyers of these securities drove prices up and yields down. Am I the only one who finds it ironic that seniors, who vote overwhelmingly for Republicans, are damning the very free market forces which have delivered low interest rates while also attending the same Tea Party rallies which deride President Obama as a socialist?
Japan's Savers' Windfall:
Finally, there is a precedent for falling rates actually helping fixed income investors and savers. Two decades of deflation and super easy money in Japan have resulted in an incredible bull run for Japanese Government Bonds precisely because falling rates cause the prices of these bonds to increase. If anything, it has been the overabundance of safe vehicles to invest in which have kept Japan mired in two decades of stagnation. Why invest in plant and equipment, real estate, or stocks, if you know rates will fall thus boosting the values of government securities or other super safe fixed income holdings? Couple this with very low inflation or even deflation as in the case of Japan, and the returns are magnified because as prices for goods fall the real value of the debt owed by the government actually increases rather than being eroded away by inflation. Indeed, Japanese banks, pension funds, and insurance companies have made spectacular returns using this very strategy. According to Warren Mosler, an economist and former hedge fund manager, the depreciation in the Yen last year was mainly do to these same entities buying foreign bonds without hedging the currency risk. While the Bank of Japan's latest round of easing has seemed to cause some Japanese names to seek yield abroad, Mosler believes they could very well revert to their old ways. Indeed, the Japanese have been net sellers of foreign securities so far in 2014.
Wanting the World:
The past five years have been tough financial times for many Americans, but seniors have done just fine. Younger Americans on the other hand face an anemic jobs market, where they are unable to utilize the skills they payed dearly to obtain at college. Meanwhile, those of us who actually work continued to foot the bill for Medicare and Social Security all through the Great Recession. While these entitlements are crucial for the security of many seniors, and thus must be preserved, it is also necessary to thank and acknowledge those who bear the cost of providing them. So I am so sorry that affluent seniors must accept lower coupon rates when they roll over their bond portfolios. But really, with medical technology ever advancing and bonds providing fat returns over the past five years, what more could a retiree ask for?
Bond Price Explosion:
While low interest rates may make it hard for new savers to earn a solid returns if building a fixed income portfolio from scratch, falling interest rates are usually a windfall who those who have existing portfolios I assume this includes all those seniors out there that "did the right thing." A few back of the envelope calculations demonstrate this. Ten year US treasury yields were at five percent in late 2007, and then plunged to two percent in the depths of the financial crisis. The underlying price of these securities therefore increased substantially, that same ten year was worth over twenty percent more in 2009 than in 2007. Yields moved up again in 2010 as some signs of recovery sprung up, only to plunge again as the Fed gobbled up more long debt instruments as part of its so-called quantitative easing program. So again, since the financial crisis risk-free assets have been an excellent opportunity for financial gain. Many say seniors could not part with the liquidity and therefore could not purchase ten year bonds. Well, the equivalent two year notes which also yielded five percent in 2007 and then dropped to 0.3 percent in 2009 saw there values soar roughly 9 percent over the same period. Not a bad return considering that the Dow Jones Industrial Average would lose over fifty percent of its value during the financial crisis.
So far from being a lack of safe investment vehicles for seniors to invest in over the past five years, those who actually did invest in the very same safe securities they claim they want have made out like bandits.
Doing Alright:
Furthermore, compared to other Americans, seniors have fared much better in the financial crisis and the great recession. While poverty rates soared for younger Americans during the Great Recession from nine to fourteen percent, the rate of poverty actually declined for those aged 65 and older from 2008 to 2011. So much for seniors being forced into the poor house because of low interest rates. Other measures of well being also point toward seniors doing okay. As this figure shows, the median net worth of 35 to 44 year olds declined a whopping 58 percent from 2005 to 2010. Seniors on the other hand experienced only a 13 percent decline in median net worth over the same period. Those under thirty five, who have little savings are usually don't own homes, saw median net worth fall by 38 percent, while prime working-aged adults, or 45 to 64, year olds experienced a 25 percent decline. In sum, since, during, and after the Great Recession, seniors have experienced less poverty, and have suffered fewer losses in terms of net wealth than the average American.
Risky Business:
Unfortunately, what I susupect is really going on is that just like everyone else, seniors were heavily exposed to the stock market in 2007, not satisfied the five percent returns offered by government bonds or other safe instruments. When things went south, they followed everyone from the Norges Bank (which oversees Norway's 800 billion dollar sovereign wealth fund) to US hedge funds into government fixed income, but the glut of buyers of these securities drove prices up and yields down. Am I the only one who finds it ironic that seniors, who vote overwhelmingly for Republicans, are damning the very free market forces which have delivered low interest rates while also attending the same Tea Party rallies which deride President Obama as a socialist?
Japan's Savers' Windfall:
Finally, there is a precedent for falling rates actually helping fixed income investors and savers. Two decades of deflation and super easy money in Japan have resulted in an incredible bull run for Japanese Government Bonds precisely because falling rates cause the prices of these bonds to increase. If anything, it has been the overabundance of safe vehicles to invest in which have kept Japan mired in two decades of stagnation. Why invest in plant and equipment, real estate, or stocks, if you know rates will fall thus boosting the values of government securities or other super safe fixed income holdings? Couple this with very low inflation or even deflation as in the case of Japan, and the returns are magnified because as prices for goods fall the real value of the debt owed by the government actually increases rather than being eroded away by inflation. Indeed, Japanese banks, pension funds, and insurance companies have made spectacular returns using this very strategy. According to Warren Mosler, an economist and former hedge fund manager, the depreciation in the Yen last year was mainly do to these same entities buying foreign bonds without hedging the currency risk. While the Bank of Japan's latest round of easing has seemed to cause some Japanese names to seek yield abroad, Mosler believes they could very well revert to their old ways. Indeed, the Japanese have been net sellers of foreign securities so far in 2014.
Wanting the World:
The past five years have been tough financial times for many Americans, but seniors have done just fine. Younger Americans on the other hand face an anemic jobs market, where they are unable to utilize the skills they payed dearly to obtain at college. Meanwhile, those of us who actually work continued to foot the bill for Medicare and Social Security all through the Great Recession. While these entitlements are crucial for the security of many seniors, and thus must be preserved, it is also necessary to thank and acknowledge those who bear the cost of providing them. So I am so sorry that affluent seniors must accept lower coupon rates when they roll over their bond portfolios. But really, with medical technology ever advancing and bonds providing fat returns over the past five years, what more could a retiree ask for?
Wednesday, February 12, 2014
Commentary: Seeking Relative Value in EM and Commodity Space
This week EM turmoil has abated and even vulnerable markets like Turkey and South Africa have stabilized. Turkey's Lira traded as low as 2.18 per dollar today, the lowest since Turkey's Central Bank hiked its key overnight rate by 400 basis points. The South African Rand has been trading around the 11 handle after reaching as high as the 11.50 level earlier this year. Other so called "risk" currencies among the industrialized nations have also outperformed this week, with AUD, NZD, and CAD all up this week. Rates appear to be on hold for AUD and CAD, despite very low Canadian inflation. Australian monetary authorities appear to be pleased with a lower AUD, with officials calling the .80-.85 a fair value for AUD/USD. CAD has been up in this week as some analysts believe the Canada's terms of trades may improve as the Brent-West Canadian Crude spread narrows. Meanwhile, New Zealand's economy appears to be picking up steam, with dairy exports surging with an accompanying pickup in domestic demand.
On FX, the RBNZ most recent statement that "In this environment, there is a need to return interest rates to more-normal levels. The Bank expects to start this adjustment soon." With CPI already at 1.6 percent, and the Bank keen to keep it below 2, most analysts expect rate increases by the end of Q2 this year. I believe higher rates could be NZD supportive, though I am hestitant to buy NZD/USD in the face of Fed tapering as the US economy picks up. Those seeking carry could consider buying NZD/JPY or NZD/CHF. Personally, I am more inclined to sell AUD/NZD since these closely integrated countries appear to have divergent monetary policy. A similar dynamic may be emerging between the UK and the Eurozone. Indeed, short EUR/GBP (which already offers modest carry) trades are gaining popularity
Looking to EM space, I still believe that investors must continue to be highly selective. MXN and KRW will continue to be outperformers. Other regional LatAM currencies have been crushed, with USD/BRL and USD/ARS soaring in recent weeks. Other countries with much stronger fundamentals have also been hit, with USD/CLP and USD/COP still up big on the EM sell off. To be sure, both the central banks of both Chile and Colombia still have an easing bias. Colombia's monetary authorities continue to fret over low inflation. On the other hand, the Bank of Mexico has very likely reached the end of its easing cycle. Its quarterly report release earlier to today stressed vigilance on inflation and the need to tighten policy quicker than expected should the broader economic recovery produce inflationary pressures. Inflation is gaining momentum in Mexico with core inflation reaching 3.21 percent, the highest since July 2013. Yesterday's IP report was more of the same, with manufacturing still humming along but construction continuing to contract. The last read on retail sales was stronger than expected, and unemployment is at the lowest level in five years. Consumers may be a position to do some heavy lifting this year. Structural reforms, especially in the energy and financial sectors should also put the economy on firming footing and attract investment flows. We'll get the first read on Q4 GDP next Tuesday.
In general, I expect ZAR, TRY, and ARS to remain under heavy pressure. I am inclined to avoid these currencies altogether, but long BRL/ZAR or long TRY/ZAR may be an interesting play to capture some carry. However, idiosyncratic weaknesses in many emerging market (labor unrest in South Africa, corruption in Turkey) may cause correlations between the "fragile five" to break down. Thus, great care is required.
On FX, the RBNZ most recent statement that "In this environment, there is a need to return interest rates to more-normal levels. The Bank expects to start this adjustment soon." With CPI already at 1.6 percent, and the Bank keen to keep it below 2, most analysts expect rate increases by the end of Q2 this year. I believe higher rates could be NZD supportive, though I am hestitant to buy NZD/USD in the face of Fed tapering as the US economy picks up. Those seeking carry could consider buying NZD/JPY or NZD/CHF. Personally, I am more inclined to sell AUD/NZD since these closely integrated countries appear to have divergent monetary policy. A similar dynamic may be emerging between the UK and the Eurozone. Indeed, short EUR/GBP (which already offers modest carry) trades are gaining popularity
Looking to EM space, I still believe that investors must continue to be highly selective. MXN and KRW will continue to be outperformers. Other regional LatAM currencies have been crushed, with USD/BRL and USD/ARS soaring in recent weeks. Other countries with much stronger fundamentals have also been hit, with USD/CLP and USD/COP still up big on the EM sell off. To be sure, both the central banks of both Chile and Colombia still have an easing bias. Colombia's monetary authorities continue to fret over low inflation. On the other hand, the Bank of Mexico has very likely reached the end of its easing cycle. Its quarterly report release earlier to today stressed vigilance on inflation and the need to tighten policy quicker than expected should the broader economic recovery produce inflationary pressures. Inflation is gaining momentum in Mexico with core inflation reaching 3.21 percent, the highest since July 2013. Yesterday's IP report was more of the same, with manufacturing still humming along but construction continuing to contract. The last read on retail sales was stronger than expected, and unemployment is at the lowest level in five years. Consumers may be a position to do some heavy lifting this year. Structural reforms, especially in the energy and financial sectors should also put the economy on firming footing and attract investment flows. We'll get the first read on Q4 GDP next Tuesday.
In general, I expect ZAR, TRY, and ARS to remain under heavy pressure. I am inclined to avoid these currencies altogether, but long BRL/ZAR or long TRY/ZAR may be an interesting play to capture some carry. However, idiosyncratic weaknesses in many emerging market (labor unrest in South Africa, corruption in Turkey) may cause correlations between the "fragile five" to break down. Thus, great care is required.
Tuesday, January 28, 2014
Commentary: Turkey Must be Steadfast in its Fight Against Inflation.
The Central Bank of the Repulic of Turkey (CBRT) hiked several of key policy rates by unprecedented amounts this afternoon. The central bank will now charge 12 percent for money overnight, up from 7.75 percent. By the same token, the bank will now pay member banks with excess reserves eight percent, as opposed to 3.5 percent it had been paying until today. The one week repo rate was raised from 4.5 percent to 10 percent. Repos, or repurchase transactions are short term funding arrangements where lenders buy highly liquid and safe financial assets from borrowers who agree to repurchase them at a slightly higher price at a specified date.
The so-called "late liquidity window" which banks can turn to if they must borrow in the final hour that markets are open, was also raised. Banks will still earn zero percent on reserves deposited with the central bank after 4 PM, however, they will now pay a hefty 15 percent for the privilege of borrowing late in the trading day, up from 10.25 percent before today's announcement.
Finally, if Turkey's implementation of monetary policy looks convoluted, that's because it is.
Rather than targeting the overnight interest rate between banks, the CBRT offers a variety of funding options to banks and which it can set by fiat rather than through open market operations. A plunging lira and chaotic markets have inspired the bank to simply its operations so as to give it a better handle on guiding markets through the turbulence. The bank stated that going forward, "central bank liquidity will be provided primarily through the one-week repo rate rather than the marginal funding rate."
Inflation has remained consistently above the CBRT's five percent target, and the central bank is making its latest move as much a fight against inflation as an attempt to stabilize the FX market. The bank affirmed that the "tight monetary stance will be maintained until there is a significant improvement in the inflation outlook."
While Turkey's economy grew 4.4 percent year on year in 2013, a dangerously high current account deficit and political turmoil connected to a corruption probe into the current government has slammed the Lira. Turkey also has one of the highest current account deficits in the world, coming in at 7.5 percent of GDP. Normally, currency depreciation would aid rebalancing of external accounts as exports were made more competitive and imports became more expensive. Unfortunately, Turkey is a special case since most of its current account deficit is fueled by its heavy dependence on foreign oil and gas. Since demand its relatively inelastic for these commodities, a fall in the lira might actually exacerbate current account imbalances as local consumers will simply be forced to cope with higher energy prices.
Markets largely cheered today's actions, sending USD/TRY down to 2.18-19 ranges after hitting an all time high of 2.39 yesterday. However, some commentators have already said the Central Bank went too far and risks appearing desperate. In general, I believe that the Bank's credibility will rest on its willingness to take further action should the markets attempt to test its nerve. The Volcker Fed need to hike rates aggressively on several occasions to tame the inflation of the late seventies and early eighties. It would therefore not be surprising if the CBRT finds itself in a similar position. The Bank also faces political pressures to keep rates low with elections coming in March. Calls to hike rates from foreign commentators have been called an "interest rate lobby" by PM Erdogan. In sum, today could even be the first step in a principled fight against inflation, or a desperate wild stab aimed at calming markets in the near term but lacking the persistence and resoluteness to fix Turkey's longterm stability issues.
Other Central Banks from Asia to Latin America have taken action since the brutal EM sell off began last week. India hiked rates 25 bps to 8.00 percent, while Peru's central bank intervene directly in the currency markets by purchasing dollars to shore up a sliding Nuevo Sol. However, it is worth noting that unlike earlier EM sell offs stoked by tapering fears, this last week's dip was probably more related to general risk aversion. The EUR rose against the dollar somewhat, but the big winners were JPY, CHF, and other safe haven assets. USD/JPY fell as low as 101.72 from recent highs in the 105.20-30 range. Treasuries yields also dipped slightly, hardly a indication that investor's fear a sudden increase in interest rates.
In general, last week's sell off made certain currencies like MXN and KRW very attractive. Although the ZAR and few other weaker EMs rallied today, that seems to be largely due to market group think. Going forward, I expect investors to become more selective and reward stronger EMs, while pushing weaker EMs like Indonesia, India, and especially South Africa down even further.
The so-called "late liquidity window" which banks can turn to if they must borrow in the final hour that markets are open, was also raised. Banks will still earn zero percent on reserves deposited with the central bank after 4 PM, however, they will now pay a hefty 15 percent for the privilege of borrowing late in the trading day, up from 10.25 percent before today's announcement.
Finally, if Turkey's implementation of monetary policy looks convoluted, that's because it is.
Rather than targeting the overnight interest rate between banks, the CBRT offers a variety of funding options to banks and which it can set by fiat rather than through open market operations. A plunging lira and chaotic markets have inspired the bank to simply its operations so as to give it a better handle on guiding markets through the turbulence. The bank stated that going forward, "central bank liquidity will be provided primarily through the one-week repo rate rather than the marginal funding rate."
Inflation has remained consistently above the CBRT's five percent target, and the central bank is making its latest move as much a fight against inflation as an attempt to stabilize the FX market. The bank affirmed that the "tight monetary stance will be maintained until there is a significant improvement in the inflation outlook."
While Turkey's economy grew 4.4 percent year on year in 2013, a dangerously high current account deficit and political turmoil connected to a corruption probe into the current government has slammed the Lira. Turkey also has one of the highest current account deficits in the world, coming in at 7.5 percent of GDP. Normally, currency depreciation would aid rebalancing of external accounts as exports were made more competitive and imports became more expensive. Unfortunately, Turkey is a special case since most of its current account deficit is fueled by its heavy dependence on foreign oil and gas. Since demand its relatively inelastic for these commodities, a fall in the lira might actually exacerbate current account imbalances as local consumers will simply be forced to cope with higher energy prices.
Markets largely cheered today's actions, sending USD/TRY down to 2.18-19 ranges after hitting an all time high of 2.39 yesterday. However, some commentators have already said the Central Bank went too far and risks appearing desperate. In general, I believe that the Bank's credibility will rest on its willingness to take further action should the markets attempt to test its nerve. The Volcker Fed need to hike rates aggressively on several occasions to tame the inflation of the late seventies and early eighties. It would therefore not be surprising if the CBRT finds itself in a similar position. The Bank also faces political pressures to keep rates low with elections coming in March. Calls to hike rates from foreign commentators have been called an "interest rate lobby" by PM Erdogan. In sum, today could even be the first step in a principled fight against inflation, or a desperate wild stab aimed at calming markets in the near term but lacking the persistence and resoluteness to fix Turkey's longterm stability issues.
Other Central Banks from Asia to Latin America have taken action since the brutal EM sell off began last week. India hiked rates 25 bps to 8.00 percent, while Peru's central bank intervene directly in the currency markets by purchasing dollars to shore up a sliding Nuevo Sol. However, it is worth noting that unlike earlier EM sell offs stoked by tapering fears, this last week's dip was probably more related to general risk aversion. The EUR rose against the dollar somewhat, but the big winners were JPY, CHF, and other safe haven assets. USD/JPY fell as low as 101.72 from recent highs in the 105.20-30 range. Treasuries yields also dipped slightly, hardly a indication that investor's fear a sudden increase in interest rates.
In general, last week's sell off made certain currencies like MXN and KRW very attractive. Although the ZAR and few other weaker EMs rallied today, that seems to be largely due to market group think. Going forward, I expect investors to become more selective and reward stronger EMs, while pushing weaker EMs like Indonesia, India, and especially South Africa down even further.
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