The Bennett Newsletter
The high value and the volatility of the NZ dollar concerns manufacturers and exporters particularly. Ultimately its value affects the whole population. There have been extended periods recently when the currency became a favoured plaything of international speculators. It also played an important part in the international carry trade. Unsurprisingly, there are advocates of capital controls and market intervention to smooth its volatility and lower its appeal.
The kiwi is traded on markets as if it were gold, oil or wheat. A study of currency markets is therefore essential and the best source is the Bank of International Settlement’s Triennial FX Survey. This is intelligently discussed by Zoe Wallis in the latest RBNZ Bulletin. http://www.rbnz.govt.nz/research/bulletin/2007_2011/2010dec73_4Wallis.pdf
The Survey shows that forex trading increased 2007-2010, albeit at a slower pace than in previous surveys. During the Financial Crisis, traders headed for the safer harbours of the Yen and Dollar. The corollary was that the kiwi was less traded in periods of risk- aversion.
Trends
The Financial Crisis brought great market turbulence, and panic in forex markets sometimes imposed sharp losses of liquidity, volatility, and increased scrutiny of counterparty risk. ”The Era of Moderation” preceding the Crisis was marked by great, unjustified confidence in a continuation of low risk and volatility. When the Crisis occurred there was bewilderment and a rush for safe havens. The volume of traffic actually increased but risk was heightened by episodes of low liquidity and huge swings.
It is probable in the “Era of the New Normal” that risk-taking will remain diminished even though the central banks intervened massively by lowering interest rates and supporting liquidity. This has not prevented mounting concern about the sustainability of sovereign debt, even though the EU and IMF have bailed out countries and created dedicated stability funds. This threat has created enhanced demand for safer currencies like the Yen, and Dollar.
Changes in risk-sentiment and volatility
The crisis brought strong risk aversion and volatility spiked at the end of 2008 when the world economy fell off a cliff. An increase in volatility increased chances of massive gains and losses. Traders trimmed their positions to lessen risk. This was partly because brokers became more cautious and increased margin requirements.
Banks also tightened. Typically they use a measure called “Value at Risk” (VAR) based on historical probability of losses. This measure understated risk, but the Crisis provided a steep learning curve. Position limits were sharply revised, and investor positions abruptly closed down. These measures perhaps increased volatility and increased currency movements.
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Counterparty Risk and liquidity
After the Lehman Brothers collapse, markets suffered a dramatic loss of confidence and liquidity dried up as lenders became hyper-cautious about their clients. I recall most banks were conscious of their own toxic assets and they believed counterparties were also compromised, and might to unable to meet their obligations. Credit tightened dramatically but the forex market increased turnover: perhaps “hot potatoes” winged from institution to institution. BIS estimates that global currency trade increased by 20% April 2007- April 2010 and averaged US$4 trillion a day!
Types of forex (FX) transactions
The Crisis increased trade in shorter term currency instruments as these had lower counterparty risk: one limits the time during which counterparties can collapse!
Spot transactions are settled in two days and the risk of counterparty collapse is more acceptable in that timeframe. Spot transactions increased their share of market transactions from 30% to 37%, 2007-2010.
FX rate swaps involve two transactions. The first when currency is purchased at spot rates and a second when the transaction is reversed at a specified date at an agreed exchange rate. This is more risky, as payments are made at the end of the contract (usually three months). This trade declined from 2007-2010 from 52% to 44% of transactions. The decline would have been greater if the Central banks had not funded swap lines. A swap line of US$15 billion was extended to RBNZ in October 2008. These swap lines ensure the availability of US dollars.
Forward FX trade increased from 11% to 13% of transactions. This trade typically occurs when a trader wants to lock in a price at a future point. The parties set a rate today but settle at a future date. The spreads on these contracts widened greatly after the Lehman shock.
FX Options give the right, but not an obligation to buy or sell currency at a pre-determined rate. These are a steady 7% of transactions.
Safe-Havens
The US$ remains the most commonly traded currency, it figures in about 85% of cross-trades. The share of trades in NZ$ has decreased but Australian transactions are increasing. There is a new trend towards “interest rate” currencies, I believe, and I suggest the NZ$ is an interest rates currency, more than a “commodity currency”. Australia is also a proxy for Asian growth.
The carry trade has reduced as speculators have suffered losses when sharp currency moves wiped out interest rate gains. Many hedge funds took a hit and unwound their positions.
NZ$
The NZ$ has been traded less by carry trade speculators as the trade seemed too dangerous, NZ interest rates declined and the TWI fell 15% in 2008. Trading is, however, picking up, especially spot trades. It is not regarded as a safe-haven and not a strong interest-rate currency.
Currency swaps involving the Kiwi have increased perhaps as banks act to lock-in funding. But the biggest trade is in FX swaps. Liquidity in the market is low, and the bid-offer spread is higher than for other currencies.
I believe the QE2 policy is a game-changer, and the NZ$ is appreciating as an interest rate currency. This will not cease until Bernanke raises.
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