AUD/USD Forward FX in 2018

We live in a far more integrated global financial network. Forward FX is one of the risk management tools for efficient global payments and to effectively smooth timeline and payment mismatches. Tutorials always refer to the time value of money and the merits of prudent risk management to limit downside risk of un-hedged exposures.

In Forward FX the interest rate differentials of the two currencies calculate a price component and equate the forward points added or subtracted to the spot rate. The mathematical examples always depict a low interest rate currency and a high interest rate currency to emphasise the merit of the product and its responsible use.

A subliminal message reinforces the notion investors should migrate available low interest rate funds within the low interest rate currency to optimize returns in the higher interest rate currency. Market participants in the high interest rate economy intuitively seek to borrow at a cheaper rate than their own domestic market.

During the recent accelerated credit cycle global banks and corporations have taken on a disproportionately large share of foreign borrowings in their liability mix predominantly in the currency offering an attractive low interest rate and the greatest liquidity, the USD. Upward pressure on US interest rates has narrowed traditional spreads for all emerging economies and in the case of Australia created an inverted yield difference. The cost of servicing existing short term US debt or undertaking debt reduction strategies is now an urgent priority for those who have heavily expanded these exposures and compromised their P& L and Balance Sheet in the process.

The prospect of these gaps narrowing or inverting further is a stark reality with 2 further hikes in the Federal Funds Rate this year and two next year to approach a terminal FED Funds rate of 3.00 – 3.50%.

The sudden and significant tightening of financial conditions is currently one of the most commented topics in global financial markets. FX Forwards deserves close commentary.

Yesterday, the 3 month implied rate of AUD/USD in Forward FX was 2.40% versus 3m BBSW @ 2.07%. This spread of 33 bpts was 10 bpts wider than the previous day.

Source: Geordie Foster-Hall | Broker ICAP | geordie.foster-hall@icap.com.au

re clients extending spot obligations into longer-term forward contracts because they are unable to deliver the previously acquired USD? Is there a liquidity squeeze in available USD for delivery?

Foreign borrowings in low yield short term USD have become economically expensive to service or repay. USD used to be like sloppy liquid “MUD”, but is fast turning into having the characteristics of a global “DUST” storm.

Emerging markets are the epicentre of vulnerability. The Bank for International Settlements published a review titled “End of QE and Rising Interest Rates: Implications for Advanced and Emerging Economies”.

This article should be read as if you were reading the referee’s review of the 1st quarter of a tough and competitive football match. They draw particular attention to the under-pricing of liquidity risks, increased interconnectedness and in general draw attention to the current array of financial stability challenges.

The Perils of Foreign Currency Debt Revisited

I have learnt to expect the unexpected in global funding and investment markets. I read a Bloomberg story on 29 June 2018 titled “China is said to Weigh Banning Short-Term Dollar Bond Sales”. It gave me an immediate sinking feeling. I thought “Oh dear, what were they thinking?”

USD Libor 1 year interest rates near 0% have been very cheap and highly attractive for many years. We now learn Chinese property developers have financed their large scale projects on these short term USD borrowings.

It appears they have side-stepped Government reporting regulations on foreign currency leverage >= 1 year by accessing 364 day USD bond issues. Hence, they have been able to increase their outstandings beyond prudent limits. This edifice of liabilities may have looked cheap and too good to pass up but it now has all the perils of elevated re-pricing risk. The old phrase, “if it looks too good to be true, then it usually is” comes to mind.

Offshore funding has merit; however, it is a fundamental risk to not fully hedge interest rate and currency exposures or manage to tight tolerances within a holistic internal and external counterparty risk management framework. Currently, risk analysts would be flagging a broad array of financial VAR movements and limit breaches in many companies right around the world due to the aggressive rise in USD Libor short-term interest rates.

Beyond just major banks, all corporate boards and senior management need to firstly quantify the impacts of their foreign currency funding lines on their own balance sheet and secondly investigate the liability profile of their own downstream domestic and global supply chain, especially those domiciled in emerging markets.

Realistically, the widely reported capital outflows across emerging markets over the last month could be directly related to USD borrowings. Productive foreign investment may not be fleeing emerging markets at all. It might be the major banks and large corporates choosing to repay or restructure their funding profile of USD short term debt to responsibly manage their floating rate costs.

Remedial actions like these can be a responsible action to undertake. We may have witnessed a phase where heavily indebted counterparties have panicked in unison. Regrettably, they have all been subjected to the same trigger event of rapidly rising USD Libor rates. Overshoot always occurs when everyone rushes to do the same thing at the same time. This is where Central Banks use discretion to smooth these flows through a balanced interplay of currency intervention and monetary policy. The Central Banks of emerging markets like India, Indonesia, Russia, Turkey and Argentina have all intervened recently to stabilise the rapid decline in their currencies. Just this week, the Chinese Yuan traded at 6.6325, its weakest level since November 2017 and rapidly approached the lower level of their trading band. If Central Banks need to hold currencies steady and within acceptable trading bands to allow domestic clients to release domestic capital to repay foreign debt then so be it. I feel these events have been orderly thus far and should stabilise.

When Australia needed to purge itself of Swiss Franc (CHF) borrowings in the late 1980’s, the restructure of State Government, Bank, Corporate and SME balance sheets was a systemic event which needed immediate triage to a wide range of casualties.

Rating agencies will be assessing the funding mix of all their clients globally to assess the credit impacts, such as the availability of substitute credit and the profile of ongoing costs which may improve or deteriorate current period earnings and overall financial strength.

The greatest tsunami of capital flight I have witnessed was one that was symmetrical to this event. The weakening of USD/Yen from 250 to 80 in the decade between 1985 and 1995 was inevitable. This global repatriation had to occur to rebalance a domestic funding mismatch. The export success of the Japanese economy to all countries for the 40 years post World War II built up a Yen based edifice of domestic debt deployed as working capital. The asset profile comprised a broadly diversified foreign asset portfolio of global sovereign and corporate bonds, golf courses, property and partnership equity in foreign businesses in all countries Japan exported to, which was largely everyone.

The speed of the repatriation was very disruptive. The worst implication of this balance sheet mismatch underpinning Japan Inc.’s export domination period came to a disastrous end when their major banks were forced to merge in August 1999. The bank consolidation period in Japan spanned 14 years from 1990 – 2004. The weight of systemic risks overpowered many of the strongest banks when valuations plummeted and fire-sale liquidation or default ensued. Notwithstanding this calamity, Japan remains the largest creditor to the world but one who certainly lost their mojo for the last 20+ years. The influence of “Japanese Housewives” pursuing the carry trade and “Belgium Dentists” in conservative fixed income products is worthy of referencing for their influence on foreign exchange trading and capital markets. I expect to see Australian SMSF’s continue to develop a broader global risk appetite. These recent events are key learnings for prudent funding, investment and business managers.

I trust this USD short-term debt symptom offers manageable impacts to the global financial system. However, I sense quantitative tightening will present a series of tectonic shifts which I trust will be rapidly assessed and remediated by the global financial community.

Why Australian Funding Costs Are Elevated Under A Stable Cash Rate

  • Demand and Scarcity Combined Unleash Powerful Forces
  • Traditional Low Cost Funding Sources Are More Challenging
  • Banks Restructure Liabilities to Optimise Bank Liability Tax
  • Multiplier Slows as Broad Money Free-falls

One key factor of profitable banking is to lend long and borrow short with adequate control of pricing margins. However, replenishing the supply of liabilities is a much more important element. A liquidity squeeze within the overall market is an environmental hazard to avoid.

The rapid rise in short-term interest rate benchmarks and the aggressive change in the shape of the yield curve since mid-February is cause for heightened awareness. There have been numerous discussion papers on recent observations and causal factors with many claiming it is a passing phase, but others believe we have transitioned to this point via a confluence of more structural changes than cyclical ones.

The new BBSW methodology is a revised modus operandi, which the market is adapting to. Have we structurally changed the way short-term funding works?

For money market dealers many carry trades or arbitrage trades are now uneconomic due to both market pricing and regulatory imposts. The new bank liabilities tax has materially shifted the willingness of the major banks to economically supply liquidity. To this end, NCD issuance has reduced by $22 billion or 12.5% in the last 12 months. Whilst the NCD market has traditionally been a source of cheap funding for ADIs, the assumed responsibility of the issuer to provide T+0 liquidity support does not sit comfortably within an LCR and NSFR framework. The steady decline in NCD issuance by all the major banks is a trend to watch.

This diminished supply of negotiable securities with minimal interest rate risk is a form of rationed liquidity, which manifests our own Quantitative Tightening. Over the last 18 months the Reserve Bank has stepped forward to provide $30 billion of net new funds to the market via Reverse Repos. At increasingly wider yields to the official cash rate, these higher funding costs make many carry trades in assets such as ACGBs out to 3 years uneconomic or marginal. Could these structural changes be influencing the rapid fall in broad money over the last 9 months to just 2.6% whilst credit growth continues to be more stable at 5.0% growth?

The velocity of arbitrage trading opportunities is constrained. Higher funding costs have breached asset yields and offer only negative earnings. Inverted yield curves offer the same characteristic of negative returns unless capital gain in the leveraged asset is assured. Australia has not only developed the sound economic performance over multiple decades that warrant us being viewed as the “Switzerland of Asia”, but we are fast developing a yield curve commensurate with the status of being seen as the “Bunds of Asia”.

On 20/6/18 BBSW 6mths rose above the 3 Yr Swap rate by 5 bpts, 2.25% vs 2.20%. Will we see the more important BBSW 3mth rate currently at 2.12% rise the remaining 8 bpts before this inverts as well? The favoured receive carry trade for swaps out to 3 years will then be viewed as uneconomic, lacking essential positive carry. A pay fixed / receive floating psychological bias may then vie for mainstream thinking simply by offering positive carry. It is an imperative to accurately forecast the demand dynamics of the BBSW curve out to 6 months relative to the path and timing of Global and Australian cash rates if you are intending to predict the ongoing influence of the interest rate swap market.

This week Australia has taken another key step toward developing a more sophisticated home and investor mortgage refinancing market on the back of our emerging low, flat, medium term yield curve. AMP announced on 19/06/18 a fixed rate loan offer of 3.79% for owner occupied borrowers with <=90% LVR. This is extraordinary, being only 20 bpts higher than Bank of Sydney’s 3.59% variable rate loan and 11 bpts over a swathe of lenders at 3.68% like Gateway Bank and CUA. I expect the recent strong demand for new liabilities by these ADIs will influence mainstream term deposit pricing well into the new financial year.

Australian mortgage borrowers are developing a real appetite to substitute their lenders at a cheaper cost. Major Bank Treasurers are likewise undertaking a similar substitution strategy looking for a better deal on their borrowings. They are progressively responding to the new US Corporate Tax policy by adjusting their foreign / domestic funding mix to immunise themselves against a diminishing pool of offshore depositors and a higher interest rate profile in Libor based funding markets.

The clear indication of a domestic funding resurgence is the reconfiguring of the positive slope of the term deposit curve we had during the last few years of fine-tuning LCR and NSFR ratios. Terming out liabilities was encouraged via low short-term rates and far more attractive long-term rates. A steep differential was the bait. Today we have quite the opposite evolving. High yield, flat curves are the new norm as they encourage all investment profiles equally. High rates for 3 months, which are either above or below long rates by 5-10 bpts are one of the main discussions points in our client conversations. Both investors and borrowers are winning at present. Term deposit yields are more lucrative, coupon resets on floating rate products like FRNs are improving for investors and term borrowings are pricing off a low, flat swap curve that shows no inclination to reinstate any term risk premium. Our clients seem to be winners all round.

The presence of the major banks in the 2 – 6 month funding sector is materially changing price dynamics of low cost funding, which has been the province of smaller ADIs. At present, it seems supply of funding for the larger banks is far more crucial than finessing net interest margin. Guaranteeing sustainable supply is the clear and present danger and challenge to all ADIs.

The dynamics of scarcity and reduced liquidity are becoming more evident in many quarters. The speech by Rob Nicholl CEO of AOFM at the ABE luncheon on 29 May 2018 warrants a re-read to understand the structural change they are proposing to their modus operandi and its impact on cash markets. Guy De Belle’s speechfrom mid March can also be viewed as a signaling statement that key risks may not be priced correctly if much tighter global financial conditions are looming.

Asset growth has to slow if liability growth is slowing. Credit rationing is already apparent. It is being commentated as a key reason in a weakening housing market. The major banks are being more discerning on client segment, loan size, location demographics and equity contributions by borrowers. Hence, borrowers are willing to explore new channels of supply. A fringe credit spectrum evolving through Fintech channels is the genesis of a private equity based shadow banking system too. Credit rationing will certainly be a catalyst for growth in this sphere.

The infant ” .V ” shaped yield curve with the dot being the low official cash rate, lofty short-term rates, lower rates from 1 – 3 years and then positive shape beyond begs the following question. If funding benchmarks such as the BBSW 1, 2 & 3 month rates (2.00%, 2.07% & 2.11%) diverge too far away from the RBA OCR (currently at 1.50%) and sustain those higher levels, then which of the following scenarios is most probable:

1. Monetary Policy remains unchanged until more compelling data emerges; or

2. Monetary Policy is tightened to endorse the higher wholesale market price; or

3. Monetary Policy is eased to alleviate the elevated wholesale market price.

Where does the highest level of financial stability lie?