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Agenda
European Sovereign Crisis The Chinese Landing Hard or Soft? Relative outperformance of Asian economies Operation Twist US Subprime Crisis Currency Markets Yen & CHF Appreciation Commodities
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Reaction to Sovereign risk gained credence with Dubai World- An investment company managing the portfolio for the Dubai Govt Efforts to tide over the crisis has been reactionary at best Markets have historically lead in pre-determining the culprits before the ECB
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Currency union enabled low borrowing rates across countries Maastricht treaty Countries pledged to keep spending in check Greece & other countries through derivatives were able to mask their deficits A squeeze in credit, coupled with a fall in asset prices accelerated the recession in these countries Market focus on PIIGS France too has entered the fray
8/11/2011 Beta Series on Finance
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Main economic drivers: Tourism & Shipping Highly cyclical both declined during recession (18% unemployment)
Political turmoil has increased uncertainty New unity govt post referendum drama
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Unemployment rate ~ 20% Lack of labor reforms such as collective bargaining by unions, high severance pay etc
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Issues
Transfer mechanisms
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Y = C + I + G + NX In the euro zone, Governments find it hard to increase NX (depreciating currency) or G (austerity measures!), I (dependent on interest rate set by the ECB), C (dependent on interest rates as well)
One will not see the unemployed from Spain making a run for Germany
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EFSF essentially raises debts in the capital markets to help distressed countries EFSF mandated to lend to countries in financial difficulties Issued EUR 3 billion bonds yesterday to help Ireland Issued EUR 3 bn bonds in June to aid Portugal
Member states guarantee up to EUR 780 billion of this debt; European Commission funds another EUR 60 bn; IMF another EUR 250 bn
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A devalued currency has typically a role to play in inflation Inflation data of China should be taken with a pinch of salt
PBOC is allowing Yuan to appreciate with respect to dollar
Chinas central bank has raised interest rates fives times since October, 2010; reserve requirement have been increased 9 times (currently at 21.5%)
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Real Estate prices in China are finally stabilizing or is the cycle about to turn ?
Steps such as high interest on mortgage payments, other credit controls has been taken Banks in China & Hong Kong have huge exposures to the Real Estate in China
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Activities linked to Real Estate account for ~25% of the total GDP of China
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Currency devaluation helps in increasing competitiveness in global markets Countries such as US are coming harder on currency controls
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Future outlook: Greater uncertainty implies that Asian central banks are likely to pause monetary tightening Capital flows could re-emerge as a policy challenge for some Asian central banks, especially if they are reluctant to allow their currencies to appreciate on a trade-weighted basis Continuing search for yield by global investors will attract them to invest in Asian markets
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Reasons for Asias outperformance: Reducing public debt levels Strengthening currency reserves Applying discipline to fiscal deficits Government packages for strengthening infrastructure etc.
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US Fed targets inflation as well as unemployment Ten year Treasuries as low as 1.95% but Unemployment 9%, Inflation 2% (but inflationary pressures rising - CPI) Sell medium term bonds ($400B) due in the next few years and buy 6-10y chiefly10y Treasuries (long term) Major interest rates (e.g. Mortgage rates, corporate bonds, long term bank loans) tied to the 10y Treasury rate Tried once before in 60s pushed down rates by 0.15% and mortgage rates by even less so it really effective? Also, treasury issuing long term securities at an even faster rate. So supply matching demand.
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BUT - 30 yr yields fell by 17bp on announcement and 2s/10s curve flattened sharply, correcting to10bp flatter May have been caused due to other effects weakening European economy, cut in IMF world growth forecast from 4.5%-4% (risk off sentiment) Support in favor of above equities/commodities fell (should have risen on announcement of a new stimulus) Fed is not printing money to fuel the risk appetite to buy risky assets and fund carry trades so no fall in dollar Dollar rose against major currencies (risk off sentiment, higher short term yields attracting short term investors)
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Fed running out of options liquidity trap. Fiscal policy out of Feds control high deficits, no stimulus Flatter yield curve reduces incentives for banks to lend fall in Net Interest Margins Bank stocks tanked Argument in support of Operation Twist Monetary Disequilibrium theory easing demand for money But yield rise on T-bills is capped by banks arbitraging between excess reserves and T-bills Expectations - Should Fed commit to a nominal income and price level target? Investment alternatives Treasuries? Gold? Stock?
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Where to invest?
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Bank
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In response, U.S. govt. introduced deposit insurance in 1934 which finally ended such bank runs A new form of depository banking emerged the repo market So who are these new depositors?
Institutional investors like pension funds and non-financial companies like Coke also need to have some accounts where they can park money But deposit insurance is limited and does not cover these huge amounts So they go to the Repo market!
Example: Fidelity has $ 500 million which it wants to keep in a safe place for a short duration say overnight
Fidelity
$ 500 mm $ 500 mm collateral Next morning, Bear repays $ 500 mm in exchange for collateral
Bear Stearns
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The asset which it gives as collateral earns a higher interest than the interest it gives to Fidelity on the $ 500 mm loan Investors like Fidelity want safe collateral, but Treasuries and AAA corporate bonds were not sufficient for this collateral demand in comes Asset Backed Securities
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Yen recently recorded post World War-II high of 75.31 against US$ (83 at start of 2011) This is hurting Japans exporters as appreciating Yen makes their goods expensive to foreign buyers What is driving the Yen up? Two theories to explain this.
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March earthquake caused destruction of life and property and therefore insurance claims Insurance companies sold assets held abroad to bring proceeds to Japan for repaying claims People who were devastated sold their foreign assets as well Did these inflows caused the Yen to rise?
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The real interest rates in the U.S. have gone negative! The Japanese real rates though low are still positive With Yen & US $ being the safe haven currencies investors flock to them at the sight of distress signals in global economy With Yen now offering higher real yields, it is the preferred choice
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Yen Appreciation
View
Short-term: Likely to strengthen given the positive real rates Risk in short-term posed by the Bank of Japan intervening to get the Yen to depreciate Medium term: Likely to weaken as the U.S. economy recovers and the real interest rates rise
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Real world Demand Supply Inflation and Price rises in other commodities Currency Linked moves: Especially Oil and Gold Tendency to high volatility Highest Cyclicity among other commodities Extremely high volatility Gold as single global currency
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Commodity Markets:Gold
The history: Traditional measure of value Gold Valuation: Foreign Exchange reserves Inflation Hedge
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Demand supply for use is small percent of total trade Links to tulips story: Is there anything intrinsic? Asian economy demands very high Tendency to high volatility
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Gold's share
Gold
tonnes
of national forex reserves(%) 74.70% 71.70% 71.40% 66.10% 1.70% 16.40% 7.10% 6.70% 3.00% 59.40% 8.10%
Rank 1 2 2 4 5 6 7 8 9 10
Country People's Republic of China Japan Eurosystem Russia Saudi Arabia Republic of China (Taiwan) Brazil India Republic of Korea Switzerland
Reserves 31,97,000 11,37,809 8,86,355 5,16,800 4,56,200 4,00,770 3,50,000 3,11,516 3,05,084 2,88,590
1 2 3 4 5 6 7 8 9 10 11 USA Germany Italy France China
Switzerland 1,040.10 Qatar Russia Japan Netherlands India 950.3 775.2 765.2 615.5 614.8
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