Markets Presentation Dec.2010

8/3/2019 Markets Presentation Dec.2010

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Markets

Discussion

Hosted by C.J.

For FCRC use only

College of Business AdministrationSeoul National University

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Fixed Income & Currency

• Central Bank (U.S.: Federal Reserve) sets the rate at which the loans are made tothe commercial banks

• Other rates (prime rates, overnight repo, treasuries, CD, CP, loan interests, notes etc.)generally move in coordination with the central bank benchmark

• What happens if the central bank lowers the benchmark rate?• People borrow more money (it‟s CHEAP!) = CASH ENTERING THE ECONOMY • (relatively safer) Bond yields decrease• Investors look for riskier investments (equity markets, real estate, new

businesses etc.)• More riskier investments = Higher chance of asset price bubble = Inflation

• What happens if the central bank raises the benchmark rate?•

People borrow less money• Bond yields increase, making them more attractive• Investors abandon riskier investments• Asset prices decline

Review: Interest Rates

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• Inflation: “Too much money chasing too few goods” • Not necessarily a bad thing: it‟s a natural byproduct of a robust, growing economy • Demand-Pull vs. Cost-Push Inflation

• Demand-pull•

More money spent than normal (low interest rates, high govt. spending)• Not enough supply to keep up with demand

• Cost-push• Cost of doing business starts to go up (labor, commodities, taxes)

• Inflation makes the currency cheaper: that is, you need more money to buy thesame good if disposable income can‟t keep up, people become poorer trouble

• That‟s why inflation makes people want to borrow NOW • Inflation and Rates: Investors want to preserve their returns by investing in activities

with yields higher than the inflation rate• Investors already invested in fixed-rate bonds will LOSE money as a result• Expected inflation can influence the rates, just like how rates affect inflation. We‟ll

talk more about this later.

Review: Inflation

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• Federal Reserve uses “open market operations” to influence thesupply of money• They set a “federal funds target rate” and sometimes moves thediscount rate too to move to the target

•

Federal funds rate: rate at which banks lend federal funds at theFed to other banks• They do this to preserve their reserve ratio (10% of total

demand accounts)• It‟s different from the discount rate, where banks take a direct

loan from the Fed• After the Financial Meltdown, the Fed bailed out many financialinstitutions and set the target rate to near zero Zero Interest Rate

Policy or ZIRP• Obvious choice at the time b/c nobody wanted to invest in risky

securities and banks wanted to reduce their books and cutlendings

• After implementing ZIRP, however, Fed could not use discount ratemanipulation as an option : this is called “The Liquidity Trap”

What’s making the Fed worry?

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• Worries about Deflation• What happens in a deflation?

• Decreasing prices for goods and services• Available hard currency per person falls•

Currency value appreciates• Discourages borrowing (hey, why borrow

today if I can borrow cheaper tomorrow?)• Decreases investment due to reduced

production capacity• Enriches creditors at the expense of

debtors• Mortgage principal example

•

Benefits fixed-income earners• Recession and unemployment: price

decrease lower production lowerwages and demand more pricedecrease

What’s making the Fed worry? (continued)

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• Fed‟s ultimate goal is to root out unemployment and get businesses and people tostart spending again• So what does a troubled Fed switches its weapon to? Buying assets or simply put,PRINTING MONEY •

Fed has had already conducted Large-Scale Asset Purchases (LSAPs=QE) to buyhousing agency debt, mortgage backed securities, and long term treasuries worth$1.75tr to:

• Affect the risk premium on the asset being purchased• Reduces the amount of security that the private sector holds, displacing some

investors, and simultaneously increases the amt of short-term, risk-free bank reserves

• Fed Purchases of the asset “bid up” the price of the asset and lower its yield

The Fed’s Answer: Quantitative Easing

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• For treasuries, this reduces the “term premium” , orreluctance of investors to bear the risk of holding a long durationsecurity• QE has removed a considerable amt of assets with long

duration from the markets (obviously; Fed bought them all)• Less duration risk market holds lower premium to holdthat risk long term yields are supposed to go down

• Original QE started from 2009• QE2 was announced November 2010 and will purchase up to$900 billion in long-term treasuries by 3Q 2011• QE2‟s long term target inflation rate = 2% •

Higher inflation will help reduced U.S fixed-rate debt burdensas U.S. pays off fixed obligation with cheaper dollars

• Relationship between a security‟s price and yield: always keep in mind!

The Fed’s Answer: Quantitative Easing (continued)

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• Long term interest rates have actually risen• Market anxiety that the Fed has lost control of rates and inflation expectations• “At some unknown point, easy money turns into

excess leverage, reduced deflation risk becomesinflation fear, fiscal stimulus becomes sovereign creditrisk.” –J.P. Morgan Chase asset allocation group-

• Investors are expecting stronger growth for theU.S. economy, which is pushing up yields

• Encouraging retail sales & producer price index• More money injected into the economy = run-

up inflation

yields go UP• Commodities price UP: investors hold morecommodities as a hedge to inflation risk

Market Reactions to QE2

Announcement of

QE2

30yr

10yr

????

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• Basic currency movements are NOT socomplicated. It just reacts to supply and demand of the certain currency in the open market

• Drawings

• All this new-found liquidity from Fed printingdollars has to go somewhere• U.S. asset prices are still lukewarm. Euro zone isin deep trouble. Where does the money go? Asia!• Investors with dollar in hand changes money toKRW, JPY, CHY, HKD, TWD to invest in assets thatgive them higher yields• Result: emerging mkt currencies become moreexpensive (you can buy less of them using 1 dollar)

• Note: JPY is not an emerging mkt currencybut its status as Asia‟s safe haven and JCB‟sZIRP attracts foreign capital

• Australia‟s high natural interest rate and strongeconomy brought USD-AUD rate to parity

Currency Reactions to QE2 (Hot Money!)

USD-KRW (6 mo)

USD-JPY (6 mo)

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Emerging Market Reactions• Why don‟t emerging markets like their currencygetting expensive?

• Exports are hard-hit• E.g: LG sells monitors to U.S. and

receives U.S. dollars They need themoney back in Won for the same

dollar they‟re getting less won • Asset price bubbles generated from foreign

capital• Sudden and massive inflows can also mean

sudden and massive outflows in the future• Countries like Korea can either:

• Direct FX market intervention: Buy USD (toincrease demand for USD, making it more

expensive)• Decrease rates (to make Won less attractive,

which isn‟t feasible) • Increasing rates is a dilemma for BOK b/c:

• It chokes off inflation but,• At the same time makes Korean assets

attractive to speculative foreign capital

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China and Currency Manipulation

• How is China manipulating Yuan?• Sells its own currency and buys up foreign

reserves like USD• China holds USD 2.4 tr – the largest holding of

USD by a country outside U.S.• This essentially “pegs” or fixes the Yuan‟s value

to USD, instead of allowing it to move freely inFX mkts

• Chinese gov‟t decided to loosen the leash on the Yuan in June 2010, allowing Yuan more “flexibility” but Yuan has only increased about 2% since

• Why is China manipulating Yuan?• Weak currency helps exports – you can take

advantage of your competitors• At the same time protects its own market by

making imports expensive• Industrialized nations think that this has

allowed China to grow at an amazing rate

USD-CNY (3 mo)

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Euro Debt Crisis

• Why is sovereign debt under the spotlight?• Gov‟t around the world need to issue debt to

finance their projects and “roll over” previousdebts

• Target amount must be raised: gov‟ts don‟t

have many options; they must give theinvestors the return they want

• Greece bailout at a glance• Greece: fastest growing economies in the

Eurozone in the 2000s• Strong economy and falling bond yields allowed

Greek gov‟t to run large budget deficit and

spend indiscriminately• Euro actually helped Greece‟s access to lower

interest rates• All failed when financial crisis hit, when its main

industries, tourism and shipping, took a 15%hit on revenues

• May 2, 2010 - €100b over 3 years bailout byEurozone and IMF

Government Deficit as % of GDP

(Formal European Limit: 2%)

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Euro Debt Crisis (continued)• In the bond market, market anxiety about asovereign bond is measure against the spread againstthe safest bond (the German bund in this instance)and credit default swaps (cost of insuring the bond)

• Ireland‟s Vicious Cycle: • Mortgage bubble burst in 2007 Investors

stopped trusting Irish banks Dublinguarantees all bank debts in 2008 Bank losses mount Dublin puts in more money Finances are stretched Investors don‟t trustthe gov‟t Bond yields rise Dublin puts inmore money to cover the interest

• In return for bailing out Greece and Ireland,creditor nations are asking for tough restructuringcalled “austerity measures” • What an austerity measure does:

• Increases tax = hurts consumer spending• Cuts gov‟t spending = hurts public projects and

social benefit programs• Restructuring the economy = massive layoffs

(think: 1998 Korea) 13

German Bund 10yr –

Irish 10yr Yield Spread




Euro Debt Crisis (continued)

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Italy 10yr

Belgium 10yr

Spain 10yr

• The Euro‟s problem as a currency: European Central Bank

(ECB) controls the overall monetary policy, but each nationgets to control its own fiscal policy

• This means that Euro countries cannot coordinatemonetary+fiscal policies

• European Power Dynamics: Germany is the biggest nationin the Eurozone, followed by France, Italy, and Spain• Germany, therefore, has the biggest voice, but needsFrance‟s agreement to reach any conclusions

• Germany has made a move to take a „haircut‟ from

investors from any bailout funds starting from 2013• Haircut: if gov‟ts were bailed out, ECB (or IMF) will

provide money to gov‟t and they will pay out fully to theinvestors. Now, with haircuts, investors will not beguaranteed the full compensation for sovereign default

• This is making the investors nervous, as seen fromSpanish, Italian, Belgian bond yields, and this anxietywill continue into 2011, with Germany refusing toexpand the bailout facility




Euro Debt Crisis:So What Does This Mean To Us?

• This year‟s Korean equity market rally can bedefined by large buy-ups from foreign investors• Always be reminded: foreign capitals enter Koreafor its strong fundamentals, but also a lot of them arespeculative capital looking to cash in from liquidityfluctuations• European banks are heavily loaded with debt – if investors in European assets have to write off theirlosses in Europe, they might have to pull back theirinvestments elsewhere to balance things out• We have to pay close attention if EuropeanFinancial Stability Facility functions properly and if Portugal and Spain can hold its ground

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KOSPI 200




Interest Rate ParityInterest Rate SwapsCurrency SwapsTROR SwapsCredit Default SwapsBasis Risk

With drawings on the boardand on spreadsheets

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Commodities

Oil

• Oil = particularly tied to the overall business cycle• Price trends: After hitting $147.27/brl in Jul 2008,prices declined due to global crisis to $33.87/brl inDec 2008…now, it‟s rising again • Demand rise: world consuming 2.5mil brl more

per day than in 2009• Both demand and supply for oil is inelastic in theshort run

• Oil users may be shocked by high prices, butthey have commitments and habits that takestime to adjust to new prices

• Oil supply is dominated by cartel of oil-producing countries (e.g: OPEC) & adding new

capacity is time-consuming and expensive• Hedge funds and investors are buying up ETFs,

futures, and derivatives related to oil, drivingup prices

• "The market sentiment is being driven by theassumption that economic recovery will translate into

a physically tighter oil market. The reality I see is thatoil production is easily keeping pace with the recovery

in demand." Tim Evans, Citi Futures Perspective

NYMEX Light Sweet Crude:

Dynamic Chart

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Commodities

Other Commodities

Sugar

Cotton

Coffee

• Broad-based commodity rally since beginning of 2010

• Weakening dollar• Healthy demand from emerging markets• Weather-related supply disruptions

• Commodities (especially agricultural) have a

strong tendency of being affected by weather• So commodities is one way you can bet on

weather – if you believe Florida is going tohave a warm summer, then go short on orange

• Investors go long on commodities to hedgeinflation risk • Gold

• People see gold as ultimate store of value• QE and dollar devaluation is making investors

flock to precious metals• Cotton

• Risen 56% in 3 mo., highest price on recordsince the American Civil War

• Sugar• Supply disruptions and export restrictions from

India

• Brazil‟s dry weather disrupted supply 18

Markets Presentation Dec.2010

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