Global Investing

Emerging market local bond rally has more legs

Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.

There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.

Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes:

From an EM perspective there is little reason to fight the rising tide of monetary policy support in the near term. Comparisons to the 2009 global carry trade are unavoidable given the scope of G-4 central bank  balance sheet expansion.

So far, around 70 percent of the gains posted by the GBI-EM index have been down to currency appreciation (see here). That could change going forward as some central banks may act to slow FX appreciation.  That’s already been happening in Brazil. Gains from the duration trade — derived from interest rate cuts — are also more or less done, analysts  reckon, because emerging central banks are more likely from here to keep interest rates on hold than to cut. J.P. Morgan adds:

Currency hedging — should we bother?

Currency hedging — should we bother?

Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.

Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).

For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).

Buy more yen… to increase reserve returns

Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.

However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.

JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.

from MacroScope:

When the euro shorts take off

Currency speculators boosted bets against the euro to a record high in the latest week of data (to end December 27) and built up the biggest long dollar position since mid-2010, according to the Commodity Futures Trading Commission. Here -- courtesy of Reuters' graphics whiz Scott Barber, is what happens to the euro when shorts build up:



Funding stress in the FX swap market

Signs of the wholesale funding stress are cropping up in the FX swaps market, with the premium for swapping euro LIBOR into dollar LIBOR over 3 months (so-called cross currency swap) rising to 141.5 basis points, which is the post-Lehman Brothers high.

The premium has skyrocketed in the past six months (back in May it was only 16.5bps) because European banks needing funds are forced to turn to the FX swap market, and other banks are reluctant to lend to European companies in the United States.

And it looks like the situation is going to get worse from here, because of weak dollar bond issuance by euro zone companies.

Euro exit-ology

Whether or not it’s likely or even a good idea, talk of Greece leaving the euro is no longer taboo in either financial or political circles.  What is more, anxiety over the future of the  single currency has reached such a pitch since the infection of the giant Italian bond market that there are many investors talking openly of an unraveling of the entire bloc. But against such an amplified “tail risk”,  it’s remarkable how stable world financial markets have been over the past few turbulent weeks — at least outside the ailing sovereign debt markets in question.

Yet, focussing on the possible consequences for Greece of bankruptcy and euro exit has now become an inevitable part of investment reseach and analysis. In a note to clients on Tuesday entitled “Breaking Up is Hard to Do“, Bank of New York Mellon strategist Simon Derrick sketched some of the issues.

One issue he pointed out,  and one raised in the September Spiegel online report, was the chance of invoking Article 143 of the Treaty on the Functioning of the European Union, which permits certain countries to “take protective measures” and which could be used to allow restrictions on the movement of capital in order to prevent a flight of capital abroad.

from Jeremy Gaunt:

When things stagnate

Goldman Sachs researchers have been hitting the history books again, trying to divine what happens to currencies when economies stagnate. Answer:  Not as much as you might think

Looking at exchange rates for years before and during "stagnation", Goldman found that year-to-year FX volatility in such periods is lower than in normal periods. But a lot of it depends on the type of stagnation.

First, an average stagnation -- a period of sub-par economic growth lasting for at least six years:

from Jeremy Gaunt:

#ThingsStrongerThanTheKenyaShilling

Twitter does have some very strange Trends. These are the things that appear on the right-hand side of the page that show what people are talking about. They more they talk, the more likely it is that something will get listed.  More often than not they are about celebrities such as Justin Bieber.

But today's Worldwide  Trends was particularly unusual.

#ThingsStrongerThanTheKenyaShilling was right up there near the top.

As the graph here shows, the shilling has taken a heavy beating since the Lehman Brother collapse. This is one reason for the Twitter outburst.  "Kenyans are getting fed up," said @oreo_junkie, whose Twitter feed states it is from Nairobi.

And judging by some of the other "answers" to the trendline, it is not a matter for levity in Kenya. "Government's resolve to fight Corruption" was one;  "Stupidity of Kenyans to  reelect the same MPs" was another.

from MacroScope:

APEC’s robots stealing the show

robot

A guide at the "Japanese Experience" exhibition talks to Miim, the Karaoke pal robot, on the sidelines of the APEC meetings in Yokohama, Japan on Nov. 10. REUTERS/Yuriko Nakao

    Miim is one of the more popular delegates at the APEC meetings in Yokohama Japan. She sings. She dances. She tosses her shoulder length hair. She may not be able to spout an alphabet soup of APEC acronyms like the other Asia-Pacific delegates. But she's still pretty lively. For a robot.

    This week's meetings of the Asia-Pacific Economic Cooperation forum have been earnest and most comprehensive . Foreign and trade ministers issued a 20-page statement about all the things they talked about -- a giant free trade zone, protectionism, the Doha round, easing restrictions on businesses, simplifying customs procedures, promoting green industries, cooperating on health and security, you name it. They also have been, and pardon my French here, excruciatingly dull. So far, the meetings and their stupefying statements have been a testimonial to Japan's skill at stating the ambiguous. Call it the opaque meetings. Journalists from around the Pacific rim have been desperately trying to find news as the 21 APEC leaders gather for their annual pow-wow this weekend.

from MacroScope:

Giant FX market now $4 trillion gorilla

Global foreign exchange has always been one of the biggest markets in the world but its exponential growth keeps accelerating. The triennial survey by the Bank for International Settlements shows global foreign exchange market turnover leapt 20 percent to $4 trillion, compared with $3.3 trillion three years ago.

FXBIS

The increase in turnover was driven by growth in spot transactions, which represent 37 percent of FX market turnover.  Turnover was driven by trading activity by "other financial institutions" -- a category that includes hedge funds, pension funds and central banks, extending a trend seen in the past several years where buyside firms are increasingly trading currencies themselves, via prime brokerage, rather than turning to interbank dealers.

Also notably, emerging market currencies are gradually increasing their share in the marketplace. Turnover of the Russian rouble has increased its share in total turnover to 0.9 percent of 200 percent (FX is double counted as transaction involves two currencies), up from 0.7 percent three years ago, while the Brazilian real rose to 0.7 percent from 0.4 percent. The Indian rupee's share rose to 0.9 percent from 0.7 percent. The dollar keeps its dominance, although off its 2001 peak, with its share standing at 84.9 percent.