Convert Your Cash

July 30, 2010

Over the past 24 hours, there has been a lot of talk about month end fixings. Therefore I think it is worthwhile to spend a few minutes explaining the forex market’s monthly obsession.

A few days ago, central banks around the world announced that the daily volume in the forex market has expanded to more than $4.1 trillion from $3.2 trillion in 2007. (These numbers are from the semi-annual reports by the central banks – we are still waiting for the Bank of International Settlement’s Triennial survey in August). The depth of liquidity in the Forex market stems from large scope of participants who are buying and selling currencies for a variety of different reasons including speculation, hedging and trade related activities.

Month end fixings relate to the adjustments that international portfolio managers need to make to their currency hedges based upon the performance of the equity markets. These portfolio managers usually reweigh their portfolios at the end of each month if moves are larger than what they had anticipated. Their Forex hedges protect their portfolios from volatility in the forex market because the worst thing that can happen is that stocks rise 10 percent but the currency falls 9 percent, erasing nearly all of the equity related gains. This month in particular, everyone is saying that U.S. dollars need to be sold on the fix because there was a sharp jump in the market value of U.S. stocks and bonds during the month of July.

Barclays published this wonderful chart showing the changes in market value over the past month:

Fixings are done at set times during the day and differ for each instrument but the most popular fixing time is at the end of day in the U.K., which is know as the London Fix. This occurs at 16:00 London Time or 12:00 NY Time. Usually portfolio managers will either leave or give orders to dealing desks to be transacted at the fixing time and price.

Getting into the specifics

Here are 2 very basic examples of how portfolio managers hedge

Example #1: U.S. Portfolio Manager

Lets assume that you are a U.S. portfolio manager with half of your holdings in American stocks and half in U.K. stocks. In the beginning of July, you have hedged 100 percent of your British pound currency risk. Since you are in the U.S., there is no need to hedge the dollar risk.

By the end of the month, the value of your U.S. stocks increased by 10 percent while the value of your U.K. stocks increased by 5 percent. If you want to maintain a 100 percent hedge, you would need sell 5 percent more pounds on July 30th to protect your portfolio against a decline in the British pound.

Example #2: German Portfolio Manager

Now lets assume that you are a German portfolio manger with 50% of your holdings in U.S. stocks and 50% in U.K. stocks.

At the end of July, you would need to sell both U.S. dollars and British pounds to re-hedge your portfolio perfectly. However more dollars would need to be sold than pounds because your U.S. dollar denominated investments increased substantially more in value than your U.K. investments.

On July 30th, you call up your bank to conduct the hedges and repeat the same process next month.

Hopefully these examples have helped you understand why everyone is talking about the need to sell dollars for the month end fix this month!

July 26, 2010

The European stress tests are now behind us and unfortunately they failed to be the buzz kill or euphoric event that was needed to break the EUR/USD out of its recent trading range. The goal of the stress tests was to restore confidence in the European banking sector, but based upon the price action in the currency and European equity markets this morning, investors were not impressed. The results scream leniency because all of the big European banks passed and those that failed were either very weak to begin with or already expected to do so. There will be no major capital injections into banks, which was what followed the U.S. stress tests and was instrumental in rebuilding confidence in U.S. banks.

Despite some intraday volatility on Friday, the EUR/USD has been virtually unchanged since Thursday. Yet the formation in the charts tell us that the currency pair is prime for a breakout. The 1.30 resistance and 1.28 support levels probably won’t hold for long even as we head into August, when the doldrums of summer are at their highest. Based upon the price action and the prospect of stronger European, weaker U.S. data this week, I believe that the breakout will be to the upside. It should be just a matter of time before the EUR/USD breaks the 1.30 level, paving the way for further gains.

EUR/USD Daily Chart

Can we Trust the Stress Test Results?

The 600 million dollar question is whether or not we can trust the stress test results. Excluding the risk of a sovereign default immediately undermined the credibility of the results as earlier this year many people in market were convinced that Greece would default on their debt. Also having such a small amount of banks fail the tests screams leniency. By only evaluating the bonds on the trading books and not those held to maturity, the tests ignored a large amount of debt on the balance sheets of banks which will receive significant backlash and criticism. The stress tests may have been modeled off the U.S. tests, but the credibility pales in comparison. When the U.S. conducted its tests, 10 out of 19 banks failed. By passing more than 90 percent of the banks, the EU did not require them to boost their rainy day fund, which in the long run would have been good. More than 50 percent of the failing banks were in Spain which could also increase focus on the country’s risks. However the Bank of Spain has a restructuring fund in place to provide support for capital shortfalls. There is no question that the results were not as tough as the market had hoped, but the event risk that the market had been obsessing over for the past month are now behind us.

Posted in 2010 eurusd forecasts, euro, forex blog

July 20, 2010

I was on the Business News Network this afternoon talking about the impact of the EU Stress Tests on the euro. Enjoy! Click on the image to access the video

Posted in eu bank stress tests, eur/usd, euro

July 20, 2010

U.S. equities turned positive, erasing triple digit losses in the second half of the NY trading session. The improvement in risk appetite also extended to currencies as safe haven flows eased out of the U.S. dollar. The British pound, Swiss Franc and commodity currencies benefited from the weakness in the greenback. The Japanese Yen moved lower which is natural when risk has improved but the sell-off in the euro reflects the difficulty of finding buyers ahead of the EU Stress Test results and particularly after most short euro positions have been shaken out of the markets. No U.S. or European economic is scheduled for release tomorrow which leaves the market’s focus on Bernanke’s testimony on the monetary policy and the economy. Although the Fed Chairman will face extensive grilling by the members of the Senate Banking Panel, currency dealers only want Bernanke to answer 3 questions:

3 Questions for Bernanke

1. Has the U.S. economy improved or deteriorated over the past few months?
2. Is the outlook for growth balanced, skewed to the downside or upside?
3. What is Plan Z?

Has the U.S. economy improved or deteriorated over the past few months?

Twice a year Bernanke heads to Capitol Hill to deliver a testimony on the nation’s monetary policy to the Senate Banking and the House Financial Service Committees. The last time he delivered what was once known as the Humphrey Hawkins testimony was in February. Back then he was relatively downbeat about the economy even though he acknowledged that values will have to be raised at some point (which he will probably mention again). The Fed’s biggest concern was the labor market and how growth will slow once the stimulus starts to fade. Fast forward to July and his prognosis seems to have come true with the housing market feeling the pain of stimulus programs expiring and the labor market relying too heavily on government programs. The latest numbers showed that Non-farm payrolls returned to net job losses last month while consumer spending fell for the second month in row. Manufacturing and service sector activity also slowed while inflationary pressures have been nonexistent. Bernanke will have no choice but to acknowledge the deterioration and could even hint that deflationary risks have grown.

Is the outlook for growth balanced, skewed to the downside or upside?

We expect Bernanke to maintain a subdued tone that should weigh on risk appetite, particularly if he admits that the economic outlook is now skewed to the downside. Back in June, more than half of the FOMC members downgraded their economic outlook dashing any hope of a rate hike before 2011. The Fed also lowered their growth and inflation forecasts, while mentioning deflation for the first time this year. In the past month, the economy has worsened, which should have elevated Bernanke’s concern.

What is Plan Z?

In response to his pessimistic outlook, members of Congress will most likely ask the Fed Chairman for contingency plans. If he could Bernanke would probably opt to lower interest values to negative levels, but that is not an option. Deferring asset sales is a given and Plan Z could include options such as encouraging banks to lend by bringing the interest paid on bank reserves to zero, reinvest capital repayments from mortgage backed securities, resume purchases of long term Treasuries or mortgage related assets, target a specific level in Treasury yield to combat deflation and linking the pledge to keep interest values low for an extended period of time to a specific condition. None of these will immediate actions that Bernanke plans to take, but they are probably all in consideration.

Usually this testimony is used by members of the Senate to express their own views and appease their constituency by appearing concerned about the economy. This will be especially true ahead of the mid-term elections in November. According to Macroeconomic Advisers, only 14 percent of the questions Bernanke was asked in the Senate in February were actually about monetary policy. A little more than 25 percent of the questions were about fiscal policy, over which Bernanke has no official responsibility. Other popular topics were the economic outlook (16 percent) and financial regulation (14 percent). A grab bag of other questions included derivatives, income inequality and China’s currency policy.

Posted in Bernanke, forex blog

July 19, 2010

For the better part of this year, the exacerbation and settling of concerns surrounding balance sheet problems in Europe has commanded the volatility in the financial markets. This Friday, it is believed the EU bank stress test results will give euro bulls the green light to take the currency above 1.30 and perhaps as high as 1.35. In fact, risk appetite in general hinges upon the outcome of the stress tests.

What is the Goal?

It is no secret that the goal of the stress tests is to restore confidence in the banking sector by proving that the financial situation within banks is not nearly as weak as many people fear. A total of 91 banks will publish their stress test results at 12:00pm NY time or 16:00 GMT on Friday. These banks represent 65 percent of the EU’s banking sector and at least 50 percent of the national banking sectors in each country. The Committee of European Banking Supervisors (CEBS) is expected to publish a statement summing up the results a minute later.

Top 5 Outstanding Questions

These are the top 5 questions that the market needs answered on Friday for the EUR/USD to sustain its gains.

1. What is the capital threshold used to determine Pass versus Fail?
2. Will more details such as the criteria and methodologies be provided other than a Pass/Fail mark?
3. What haircut will be used to mark down government debt?
4. Will the decline in bond prices be written off as temporary for permanent?
5. If banks fall short of capital requirements, how long will they have to raise funds?

The European Union and the CEBS have not provided details on what threshold will be used to determine whether a bank has passed the stress test and if the results will contain more detail than a simple pass/fail label. Six percent has been circulated as the passing threshold for core tier 1 capital, but that has not been confirmed or denied by regulators. If a bank falls short of the threshold, it is also unclear how long they have to raise the funds and where it will come from. Another outstanding question is the haircut for sovereign risk, which is the amount that the bonds would be written down to account for default risk. Once again, unconfirmed numbers have also been floated around for haircuts with the media reporting a loss assumption of 17 percent on Greek debt and 3 percent on Spanish bonds. If these are the percentages that they go with they are too modest and will not provide much confidence to investors because of the risk of default is seen to be much greater. Some people are calling for regulators to apply a haircut of 50 percent on Greek debt but they would never do so because the point of the tests is to restore confidence and not to exacerbate aversion. Whether the decline in bond prices is judged as temporary or permanent will determine how the assets will be treated and if they are marked to market or held to maturity. There have been a lack of common procedures amongst the regulators in the region and if the details of how the banks were tested are not revealed, it could create more confusion than transparency.

Will the Stress Tests Really Help the Euro?

For currency dealers, the most important question is how the results will impact the EUR/USD. The hope is that it will provide the same support to European Financial markets as the U.S. tests did for the U.S. Yet it is important to realize that the results of the U.S. bank stress tests did not help the U.S. dollar. In fact, the greenback has sold off aggressively against both the euro and Japanese Yen since May 7th, 2009. Of course, the weakness of the dollar was a reflection of safe haven flows easing and not concerns about the U.S. banking sector exacerbating. In fact, the performance of U.S. stocks confirms that the stress tests were a big success. Therefore as long as the results provide sufficient answers to the top 5 questions outlined above, the EUR/USD should receive a nice boost following the announcement. However if any of the 5 questions are insufficiently addressed and we think this is a significant risk, there could be a classic buy the rumor sell the news move in the EUR/USD that causes it to give up recent gains.

Performance of USD/JPY after U.S. Stress Tests

Performance of U.S. Equities after U.S. Stress Tests

Posted in eu bank stress tests