College of Business Administration Seoul National University

For FCRC use only

Hosted by C.J.

Markets Discussion
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Fixed Income & Currency

Review: Interest Rates

Central Bank (U.S.: Federal Reserve) sets the rate at which the loans are made to the 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 (its 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

Fixed Income & Currency

Review: Inflation
Inflation: Too much money chasing too few goods Not necessarily a bad thing: its 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 the same good if disposable income cant keep up, people become poorer trouble Thats 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. Well talk more about this later.

Fixed Income & Currency

Whats making the Fed worry?

Federal Reserve uses open market operations to influence the supply of money They set a federal funds target rate and sometimes moves the discount rate too to move to the target Federal funds rate: rate at which banks lend federal funds at the Fed to other banks They do this to preserve their reserve ratio (10% of total demand accounts) Its different from the discount rate, where banks take a direct loan from the Fed After the Financial Meltdown, the Fed bailed out many financial institutions 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 cut lendings After implementing ZIRP, however, Fed could not use discount rate manipulation as an option : this is called The Liquidity Trap

Fixed Income & Currency

Whats making the Fed worry? (continued)

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 lower wages and demand more price decrease

Fixed Income & Currency

The Feds Answer: Quantitative Easing

Feds ultimate goal is to root out unemployment and get businesses and people to start 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 buy housing 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

Fixed Income & Currency

The Feds Answer: Quantitative Easing (continued)

For treasuries, this reduces the term premium , or reluctance of investors to bear the risk of holding a long duration security 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 hold that 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 QE2s long term target inflation rate = 2% Higher inflation will help reduced U.S fixed-rate debt burdens as U.S. pays off fixed obligation with cheaper dollars Relationship between a securitys price and yield: always keep in mind!

Fixed Income & Currency

Market Reactions to QE2

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 becomes inflation fear, fiscal stimulus becomes sovereign credit risk. J.P. Morgan Chase asset allocation group-

10yr

Announcement of QE2

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30yr

Investors are expecting stronger growth for the U.S. economy, which is pushing up yields Encouraging retail sales & producer price index More money injected into the economy = runup inflation yields go UP Commodities price UP: investors hold more commodities as a hedge to inflation risk

Fixed Income & Currency

Currency Reactions to QE2 (Hot Money!)

Basic currency movements are NOT so complicated. It just reacts to supply and demand of the certain currency in the open market Drawings All this new-found liquidity from Fed printing dollars has to go somewhere U.S. asset prices are still lukewarm. Euro zone is in deep trouble. Where does the money go? Asia! Investors with dollar in hand changes money to KRW, JPY, CHY, HKD, TWD to invest in assets that give them higher yields Result: emerging mkt currencies become more expensive (you can buy less of them using 1 dollar) Note: JPY is not an emerging mkt currency but its status as Asias safe haven and JCBs ZIRP attracts foreign capital Australias high natural interest rate and strong economy brought USD-AUD rate to parity
USD-KRW (6 mo)

USD-JPY (6 mo)

Fixed Income & Currency

Emerging Market Reactions

Why dont emerging markets like their currency getting expensive? Exports are hard-hit E.g: LG sells monitors to U.S. and receives U.S. dollars They need the money back in Won for the same dollar theyre 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 (to increase demand for USD, making it more expensive) Decrease rates (to make Won less attractive, which isnt 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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Fixed Income & Currency

China and Currency Manipulation

USD-CNY (3 mo)

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 Yuans value to USD, instead of allowing it to move freely in FX mkts Chinese govt 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

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Fixed Income & Currency

Euro Debt Crisis

Why is sovereign debt under the spotlight? Govt around the world need to issue debt to finance their projects and roll over previous debts Target amount must be raised: govts dont have many options; they must give the investors 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 govt to run large budget deficit and spend indiscriminately Euro actually helped Greeces 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 by Eurozone and IMF
Government Deficit as % of GDP (Formal European Limit: 2%)

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Fixed Income & Currency

Euro Debt Crisis (continued)

In the bond market, market anxiety about a sovereign bond is measure against the spread against the safest bond (the German bund in this instance) and credit default swaps (cost of insuring the bond)
Irelands Vicious Cycle: Mortgage bubble burst in 2007 Investors stopped trusting Irish banks Dublin guarantees all bank debts in 2008 Bank losses mount Dublin puts in more money Finances are stretched Investors dont trust the govt Bond yields rise Dublin puts in more money to cover the interest

German Bund 10yr Irish 10yr Yield Spread

In return for bailing out Greece and Ireland, creditor nations are asking for tough restructuring called austerity measures What an austerity measure does: Increases tax = hurts consumer spending Cuts govt spending = hurts public projects and social benefit programs Restructuring the economy = massive layoffs (think: 1998 Korea)

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Fixed Income & Currency

Spain 10yr

Euro Debt Crisis (continued)

The Euros problem as a currency: European Central Bank (ECB) controls the overall monetary policy, but each nation gets to control its own fiscal policy This means that Euro countries cannot coordinate monetary+fiscal policies European Power Dynamics: Germany is the biggest nation in the Eurozone, followed by France, Italy, and Spain Germany, therefore, has the biggest voice, but needs Frances 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 govts were bailed out, ECB (or IMF) will provide money to govt and they will pay out fully to the investors. Now, with haircuts, investors will not be guaranteed the full compensation for sovereign default This is making the investors nervous, as seen from Spanish, Italian, Belgian bond yields, and this anxiety will continue into 2011, with Germany refusing to expand the bailout facility

Italy 10yr

Belgium 10yr

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Fixed Income & Currency

KOSPI 200

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

This years Korean equity market rally can be defined by large buy-ups from foreign investors Always be reminded: foreign capitals enter Korea for its strong fundamentals, but also a lot of them are speculative capital looking to cash in from liquidity fluctuations European banks are heavily loaded with debt if investors in European assets have to write off their losses in Europe, they might have to pull back their investments elsewhere to balance things out We have to pay close attention if European Financial Stability Facility functions properly and if Portugal and Spain can hold its ground

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Fixed Income & Currency

Interest Rate Parity Interest Rate Swaps Currency Swaps TROR Swaps Credit Default Swaps Basis Risk
With drawings on the board and 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 in Dec 2008now, its rising again Demand rise: world consuming 2.5mil brl more per day than in 2009 Both demand and supply for oil is inelastic in the short run Oil users may be shocked by high prices, but they have commitments and habits that takes time to adjust to new prices Oil supply is dominated by cartel of oilproducing 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, driving up prices "The market sentiment is being driven by the assumption that economic recovery will translate into a physically tighter oil market. The reality I see is that oil 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
Sugar

Other Commodities
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 to have a warm summer, then go short on orange Investors go long on commodities to hedge inflation 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 record since the American Civil War Sugar Supply disruptions and export restrictions from India Brazils dry weather disrupted supply

Cotton

Coffee

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