As the Fed provides clarity over its plans to start slowing QE3, but ultimately decides to hold off on tapering its massive monthly $85 billion bond program - Udi Sela, Vice President of the Client Solutions Group and Numerix CMO Jim Jockle sit down to discuss the impact of this announcement.
This blog examines what currencies have been most impacted and how vulnerable emerging market economies are to this change. Udi also speaks to sophisticated users of FX options and FX strategies addressing what they need to be concerned about in terms of hedging against adverse market moves i.e. With tapering postponed is the market seeing good hedging levels against weakening EM currencies?
Jim Jockle (Host): Hi welcome to Numerix Video Blog, I’m your host Jim Jockle. With me today, Solution Vice President of Product Management, Udi Sela. Udi, how are you today?
Udi Sela (Guest): Not too bad. Thank you. Great to be here again.
Jockle: Thank you. And joining us from our London office today, the man of the world. I want to talk about to taper or not to taper. And the ongoing - what has been categorized as schizophrenia by the U.S. Fed as it relates to the reduction of quantitative easing. Udi perhaps you could take us a quick walk through and summarize really what the crux of the recent Fed announcement is, as it relates to starting the taper.
Sela: Yeah certainly Jim. So it all started in May. When Ben Bernanke basically announced that the Fed might be slowing down tapering. Instead of purchasing what I believe is $85 Billion worth of bonds a month. The Fed may reduce the pace. As a result, as soon as this came out it was more or less mid-May. First of all, the first thing that happened the yield on the ten year note went from 1.65% all the way to 3.00%. Almost 3.00% at the peak, 2.99%. That’s a huge move in terms of price. And the second thing is the reaction in many emerging market - currencies weakened.
Just to give some examples, if you look at the dollar Brazil it went from 2.01 all the way to 2.45 at the peak. The South African Rand went from 8.95 in May to 10.31. The Indian Rupee weakened massively from 54 to almost 69 Rupees a dollar. And so on. And so basically what happened, is that the Fed has the bi-monthly committee. And the market was expecting that this tapering would start. So instead of buying 80-85 billion worth of bonds, the market expected something like 70 billion, in terms of dollars of course, buying those bonds.
So it (the Bond purchasing) would slow down during Q3. Eventually the Federal Reserve has decided (on August) not to taper. And then there was a significant mismatch (with the market’s expectations). So in other words, the U.S. Fed’s decision has surprised the markets. (Rate) decisions that have been taken in the U.S. have impacts across all markets: commodities, Foreign Exchange fixed income, equities and so forth.
Jockle: So you’ve talked about some of the reactions within emerging markets. With this kind of reversal, have we seen a bounce back on those currencies?
Sela: Yes we definitely have. But perhaps before that, like you’ve mentioned, that the weakening in the respective emerging market currencies have been selective. Those economies with a huge trade gap or deficit, those economies local currencies have weakened much more. So if you look at India, Indonesia, these are currencies that have weakened significantly because the trade deficit is much larger. If you look at countries like Taiwan, the weakening was much less significant, Mexico, and so on. For instance the deficit in India is about five percent (the trade deficit).
Therefore, the market was very much concerned with the change and the fact is, what people call "hot money," that went to higher paying currencies, would go back to the U.S. and indeed that’s happened since the beginning of this year. And we actually have had quite amazing numbers through the end of August; $7.6 billion have been pulled from emerging markets. At the same time $102 billion went to the U.S. 28 billion went into Japan. And this is with “Abenomics”.
Even in Europe, had a positive lift of 4.3 billion. People were basically fleeing those emerging market currencies and actually going back into the more developed countries and economies.
Jockle: So thinking back to a conversation we’ve had on this video blog around an article that you wrote, back when we were looking at volatility of pairs. And the development of double no touch options or reemergence of double touch no option type strategies. Because of the low volatility in these pairs, given this kind of, new spikes, because of the uncertainty around QE3, what should those in the FX world be thinking about today in terms of managing through these times of volatility and uncertainty?
Sela: So clearly, as long as there’s positive rallying into emerging markets, this was very good for local importers (as the local currencies strengthen). So let’s say you’re an Indian company and you’re exposed to commodities. There was a great time to hedge the local exposure because typically the currency for commodities is the U.S. dollar (which has weakened against these local currencies). That was a great level to hedge. Now you also asked me about the relief rallies. There was some kind of – I’d say that the market gave back five percent from the move up. So if the local currencies have weakened by 10 percent (in average), the recovery was something like five percent. So now you as a hedger, you should definitely consider hedging the upside, or the strengthening of the U.S. dollar, and typically options that could be used for that. I’m not sure I would use a double no touch option because it can’t really be considered a hedge, but you could definitely use options that we call Knock out – so you buy a call option protecting the upside (Call Dollar) with a knock out on the downside (suitable for local importers).
So if there is a recovery (of the market), the option that you bought, would knock out but the overall premium is cheaper (and now you can buy your dollars at the prevailing – cheaper market price). But that’s one thing. Now if you’re an exporter you may want to use those levels because we’re still trading at spot levels higher than levels when Bernanke spoke first in May, which could be good levels to hedge receivables so actually hedging the downside.
What we have seen a lot, is that we see also investors, looking at volatility as an asset class. So clearly the volatility has increased in those emerging markets like Turkey, or Brazil. And if you think that, for instance the spike in volatility and weakening of local currencies is gone, perhaps it could be an interesting level to enter a Variance swap. Or in other words, bet on a lower future volatility level. If you think the U.S. is up to recovering then you may want to take the other side of the trade. I mentioned earlier that the 10 year note went up to 3 percent and now it’s (the yield) down to 2.6% (so perhaps now is an interesting entry level).
Jockle: Well Udi I want to thank you so much and I want to come back to you in a few weeks if we can. Clearly there is a lot of uncertainty going on right now in terms of pending U.S. potential shut down. Markets are very pensive around that. Changes in the Fed in terms of tapering in QE3. As well as changes of the FED leadership. So there’s a lot to talk about. Clearly a lot of implications within FX, and I definitely want to pick your brain going forward. And for those of you in the audience as well, we want to hear the questions and get to the questions you want. Feel free to follow us on twitter @nxanalytics. This is something that we will definitely be staying on top of. Udi thank you so much for your time today.
Sela: Thank you for having me Jim that was a pleasure.
Jockle: Always. And we’ll talk to you soon.
Sela: Thank you goodbye.