It was a traumatic week on world financial markets even for those of us with many decades of market experience.
Intra-day volatility was even more dramatic than the end-of-day trading data. On Thursday the Australian sharemarket was looking extremely sick and was down more than 5 per cent at lunchtime, only to rebound and finish “just” 1.3 per cent down for the day.
On the same day the New Zealand dollar was in free fall as it plunged from US71.5c to US68.2c, only to finish at US69.2c on the local market.
The fall in the kiwi is easy to explain but the sell-off on other financial markets is due to a number of complex issues including the US sub-prime mortgage market, massive leverage and exotic debt instruments that have been aggressively sold as low-risk investments by fee-hungry investment banks.
At the beginning of the year the four major domestic banks were predicting the NZ dollar would weaken and finish the 2007 year between US58c and US63c and A79c and A81c. At the start of the year it was US70.6c and A89.2c.
The forecasters had egg on their faces during the first half of the year as the carry traders drove the New Zealand dollar higher and higher.
The essential characteristic of the carry trade is that an investor borrows money in a low-interest-rate country, uses this money to buy the currency of a high-interest country and then invests this money to take advantage of the high rates.
The most common carry trade has been between Japan, where the official interest rate is only 0.5 per cent, and New Zealand, where interest rates have risen from 7.25 to 8.25 per cent since the end of 2006.
The 7 per cent margin spread has been very attractive to carry traders and has been a major contributor to the rise and rise of the kiwi up to the third week in July.
But the carry trade is based on leverage, which exaggerates both the upside and downside of asset price movements. Many of the carry traders were hedge funds that leveraged their New Zealand dollar position.
Theoretically, a hedge fund might borrow the equivalent of $9 million in Japanese yen, add $1 million of its own capital and buy $10 million of NZ dollars with the hedge fund carrying the currency risk.
The leverage in this example was particularly rewarding as long as the kiwi remained steady because the net annual interest of $700,000 on a carry trade of $10 million represents a 70 per cent return on a hedge fund’s $1 million of invested capital.
Carry traders believed they had a one-way bet on the NZ dollar as Reserve Bank Governor Alan Bollard hiked interest rates and continued to make gloomy comments about domestic inflation.
The NZ dollar peaked against the US dollar and yen on July 24 and since then it has fallen 16.4 per cent and 22.1 per cent respectively against them.
This would have wiped out our theoretical hedge fund’s invested capital.
Carry traders are now under enormous pressure from their lenders as the value of their security, particularly NZ dollars, has fallen sharply. They are being forced to sell kiwi to meet margin calls and this is accelerating the currency’s decline.
The original forecasts for December 2007 of between US58c and US63c and A79c to A81c may prove correct, although most forecasters have raised their predictions since these were made earlier this year.
The major issues that continue to affect financial markets are the US sub-prime mortgage market and the huge number of leveraged fixed-interest products sold to investors in recent years. The Macquarie Fortress New Zealand Notes were covered in this column last week and the Forsyth Barr sponsored Credit Sails issue, which has had a credit rating downgrade, was in the news this week.
These leveraged fixed-interest products are extremely complex and usually involve a mix of swaps, notional cash deposits, credit premium income, income from collateral, simulation of risk, credit strategy losses and many other wonderful concepts invented by the investment banking community.
These products have a notional or actual investment in a wide range of corporate bonds or loans and these instruments are evaluated by the major credit rating organisations, particularly Standard & Poor’s and Moody’s.
June 12 was the turning point for credit markets because that was the day Standard & Poor’s released a research paper on leveraged fixed-interest products, particularly CLOs (collateralised loan obligations). The credit rating agency believed that there had been a shift in the balance of power from investors (lender) to corporates (borrower). As a result, many credit issues had been incorrectly priced as far as risk goes.
As the pricing of most of these products is determined by the credit ratings, the research report has had a major impact on credit markets, particularly as it was released while there were concerns about the sub-prime mortgage market in the US.
Lower-quality bond prices have fallen and the spreads between buyers and sellers have risen sharply. Many leveraged fixed-interest funds are faced with the same situation as carry-trade participants with their lenders forcing them to sell securities or to front up with additional security.
This credit crunch has spread to sharemarkets, even though most of the problems are embedded in credit and currency markets with hedge funds playing a major role.
It is very difficult to know how deep these problems go because there is relatively little public information on hedge funds, credit markets and currency markets.
The impact of these leveraged structures can be clearly seen on New Zealand financial markets. The unwinding of the leveraged carry trade has had a huge impact on the kiwi but the share and debt markets have performed relatively well over the past 30 days (se table) because few leveraged fixed-interest products have been issued here.
The credit crunch has created enormous uncertainty on financial markets but it also signals a major shift in power from borrowers to lenders. In other words, we have gone from a situation of too much cash chasing too few investments to an environment where the demand by borrowers could well exceed the amount of cash available from investors, particularly as far as low-quality debt is concerned.
This means that high-risk debt issues will have to offer higher interest rates to attract funds.
The tighter credit conditions were evident in New Zealand this week when Origin Energy ($250 million), Rabobank ($400 million) and Yellow Pages ($300 million) all announced debt issues while Summerset cancelled its $300 million equity raising.
Rabobank may be trying to take advantage of competitors that may be overexposed to the leveraged debt sector while Origin Energy and Yellow Pages are probably hoping to raise money at low rates before investors realise that they are now in the driver’s seat.
The Yellow Pages issue, details of which will be announced on Monday, is being awaited with interest.
This offering would have shot out the door a few months ago at a relatively low interest rate. But in light of the vastly different market conditions, Yellow Pages will now have to offer a much higher interest rate if it is to attract widespread investor interest.
Market Turmoil: NZ dollar takes the biggest hit
|Last 30 days
|Since December 31, 2006
|NZ$ v Yen
|NZ$ v US$
|NZ$ v Aust$
Sharemarket figures are in local currencies.