Revisiting Taiwan: new disclosures, pricey hedges, late-day jumps & a new policy direction?

During early March, when the current pandemic started to spread globally, Taiwan’s central bank for the first time publicly responded to concerns about its FX derivative interventions raised by our joint work with Brad Setser last year. In this context, it seems appropriate to revisit this matter again. There will be three broad sections:

  1. The publication of the hitherto only individually published chapters as one comprehensive paper, intended to ease navigation of the argument presented last year.
  2. A new Addendum chapter was added to the paper and is also printed in full below. It recaps the official response to the paper since initial publication last October through April 2020.
  3. The actual core of this post, which starts with data updates of the CBC’s and lifers’ activities since last October, before then pondering how the CBC’s new transparency, the richness of TWD offshore and the renewed occurrence of late-day depreciations of the currency may provide insights into the CBC’s policy direction going forward.

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Continue reading “Revisiting Taiwan: new disclosures, pricey hedges, late-day jumps & a new policy direction?”
Revisiting Taiwan: new disclosures, pricey hedges, late-day jumps & a new policy direction?

Addressing overseas USD funding conditions & the Fed as global collateralized LoLR

The domestic policy response by the Federal Reserve to the current health crisis has thankfully been swift. While monetary policy makers across the world understandably focus on dislocations in their domestic markets first, in a globalized and, more crucially, dollarized world, it falls to the Fed to attenuate global USD funding pressures in order to guarantee the medical response to unfold as unconstrained as possible.

US policy makers have to date largely followed the 2008/09 playbook by reestablishing FX swap lines with foreign central banks. While no doubt necessary, these highly unusual conditions, further strained by understaffed desks, may impede transmission mechanisms and require streamlining or expansion of the Federal Reserve’s international response.

Two ideas will be discussed in this post:

  • Expanding the role foreign central banks play in the transmission of USD liquidity by installing them as temporary, localized ‘primary dealers’.
  • Instead of reliance on only passive, auction-style provision of USD via currency swap lines, which require pledging of preexisting collateral by local banking systems, central banks might consider also offering USD via regular FX swaps, allowing much more seamless transmission by intermediaries to the buyside. This format would open the possibility of intraday backstopping and/or targeting of X-CCY markets by the recipient central bank alone, or in conjunction with the Federal Reserve via US regulated intermediaries.

Implementation of both ideas would seem relatively straight forward, leave the Federal Reserve in a at minimum as secured position as under current programs, move the USD liquidity provision offshore to an intraday format (as onshore) and eliminate unnecessary strains on US dealers, which currently have to absorb international spillovers.

Continue reading “Addressing overseas USD funding conditions & the Fed as global collateralized LoLR”
Addressing overseas USD funding conditions & the Fed as global collateralized LoLR

Shadow FX intervention in Taiwan: Mercantilism, excessive private FX risks & the hedging backstop

This is the sixth and concluding chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter VI. connects the rather abstract previous five chapters with the real world by laying out their implications in a variety of dimensions:

  • The impact of far larger than previously known FX interventions by Taiwan’s central bank on the U.S. Treasury’s currency policy.
  • The CBC’s (deliberate?) influence in incentivizing private sector institutions in Taiwan to assume FX risks worth almost USD 500bn (~80% of GDP). Previous Balance of Payment turmoil usually followed FX mismatches originating from the liability side of a nation’s balance sheet – is Taiwan the first case the asset side is the driver?
  • The CBC’s dominant influence in the pricing of X-CCY basis markets in Taiwan. Would lifers’ overseas investments be even profitable without the central banks off-market FX swaps?

A quick personal end note, I can return to markets professionally next year, but details are not yet finally set. Should you find the thinking in these pages helpful, feel free to get in touch.

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Shadow FX intervention in Taiwan: Mercantilism, excessive private FX risks & the hedging backstop

Shadow FX intervention in Taiwan: the CBC’s USD 130+ bn FX swap book

This is the fifth chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter V. forms the core of the essays and seeks to answer how and to what degree the Central Bank of the Republic of China (CBC) is active in TWD FX derivative markets.

Taiwan’s central bank, unusually, does not disclose its position in FX derivative markets, and thus its true foreign exchange exposures. But its true exposures can be estimated using similar statistical techniques applied in evaluating an investment fund’s underlying positions from its profit and loss statements. Based on profits and losses which Taiwan’s central bank does disclose, it appears that its true FX exposures exceed its disclosed foreign exchange reserves by USD 130bn, and perhaps as much as USD 200bn.

Chapter V. has four broad sections:

  • An analysis of the CBC’s own statements about its activities in FX derivative markets.
  • The peculiarities in accounting for FX swaps on a central bank’s balance sheet.
  • A general method to estimate FX derivative exposures a central bank takes based on its published PnL.
  • The application of this model to Taiwan.

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Shadow FX intervention in Taiwan: the CBC’s USD 130+ bn FX swap book

Shadow FX intervention in Taiwan: Counterparties I

This is the fourth chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Given life insurers’ USD 250bn FX hedging needs, chapter IV. examines potential counterparties to these positions by private sector actors. Overseas investors, Taiwanese banks and Taiwanese non-financial corporates are all long USD in FX forward markets – but nowhere near matching lifers’ requirements.

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Shadow FX intervention in Taiwan: Counterparties I

Shadow FX intervention in Taiwan – Current Account surpluses & the Rise of Life Insurers

This is the second and third chapter in a series on Taiwan’s life insurers and their private & sovereign FX hedging counterparties. It’s the product of a collaboration with Brad Setser of the Council on Foreign Relations.

Chapter II. focuses on Taiwan’s Balance of Payments and the transition from the central bank to the life insurance industry recycling the country’s large current account surpluses. A deep dive of lifers’ management of their vast overseas fixed income books follows, with a special eye on the FX risk they lay off in FX derivative markets.

Chapter III. is a quick primer on the instruments most commonly used by institutional investors to manage FX risk, ahead of more technical chapters next week.

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Shadow FX intervention in Taiwan – Current Account surpluses & the Rise of Life Insurers

U.S. repo markets & the ‘Inverted Supply’ response of the Fed’s Foreign Repo Pool

After more than a decade without appearing in major news headlines, U.S. repo markets did their best last week to catch up and highlight what may happen in money markets in an environment of lesser reserve abundance than previously.

The general story has been told extensively in other places and the deeper final causes are yet to be established. In brief, U.S. Treasury repo rates began climbing broadly last Monday, before spiking notably on Tuesday to, in some segments, levels not seen for decades. Spillovers extended into adjacent markets, the Effective Federal Funds Rate traded far above IOER and its policy band, highly rated overnight financial Commercial Paper rates increased by 25 bps, while its less liquid companions in the non-financial and asset-backed realm increased by more than 200 bps at their peak.

Although slow to heed calls for a standing repo facility to address potential bottlenecks to date, the NY Fed was, after initial technical difficulties, in markets, offering up to USD 75bn in an overnight repurchase agreement operation with primary dealers. USD 53bn was pulled on Tuesday, and the full amounts offered of USD 75bn for the remainder of the week, in repeats of Tuesday’s operation.

As a result, temporary stress in repo (and adjacent) markets has receded, while the NY Fed upped its schedule of liquidity provisions by announcing it “will offer daily overnight repo operations for an aggregate amount of at least $75 billion each, until Thursday, October 10, 2019” and “will offer three 14-day term repo operations for an aggregate amount of at least $30 billion each” this week.

Coincidentally, the size of to date conducted overnight repos of USD 75bn almost mirrors the increase in the Federal Reserve’s foreign repo pool since the start of the year. Since a series on said pool was published three years ago in these pages, it seems an opportune moment to update developments surrounding it and its, at minimum indirect, effects on the repo stress last week.

Continue reading “U.S. repo markets & the ‘Inverted Supply’ response of the Fed’s Foreign Repo Pool”
U.S. repo markets & the ‘Inverted Supply’ response of the Fed’s Foreign Repo Pool

Introduction of a new & market-oriented section to the blog

In the last couple of years, this blog has served as an occasional notepad in an attempt to stay on top of some of the larger cross-border capital flows of the post-crisis era.

These observations will (hopefully) continue in the future, despite some personal changes recently.

As a result of these changes, a new & more market-oriented section will be added to the blog going forward. The new section can be found here and will require an invitation*. This design is not intended as an entry barrier (just shoot me an e-mail** including your name and affiliation in case of interest), but rather as a way to communicate somewhat safely in a semi-public fashion.

Continue reading “Introduction of a new & market-oriented section to the blog”
Introduction of a new & market-oriented section to the blog

FX-hedged yields, misunderstood term premia and $1 tn of negative carry investments


This stand-alone post is the long form discussion of a topic briefly touched on here. It can be read on its own, however a fuller perspective is possible when read as part of a series which starts here.


FX-hedged bond investments from overseas investors have, as shown in the main post, become an integral part of inflows into U.S. debt markets since 2008, accounting for around $1 tn worth of purchases from Asian liquidity-rich countries (most notably Japan, Taiwan and Korea) and European countries, intermediated through mutual funds.

The phenomenon is not constrained to USD-denominated debt only, although it constitutes by far the largest single currency in such currency-hedged structures, with EUR a distant second.

Estimates of worldwide FX-hedged bond investments (independent of target currency) are hard to come by, but usually exceed $2 tn. The rationale for such investments is usually seen in the search for higher-yielding, but still relatively safe assets.

In relation to the size of these flows, the analytical presentation on which such transactions are based and according to which their profitability is assessed, oftentimes appears superficial. Superficial in the sense that considerations are frequently reduced to easily illustrated rule of thumb shortcuts which at best portray parts of currency-hedged investments accurately and at worst vastly overestimate their return potential.

Most such, usually graphically presented, shortcuts are based on a combination of:

  • An assumption that risk-free interest rate differentials alone are reasons enough to invest in FX-hedged “high-yielders.
  • A belief that the shape of the yield curve in the target country at trade initiation – where steep is considered positive – is predictive of return potential.
  • A notion that once these trades are put on, the prospective return (when held to maturity) is locked in.

As none of these assumptions is fully accurate (at least without a large set of constraints), this post attempts to take a comprehensive look at the mechanics and accounting involved in establishing and evaluating a currency-hedged bond portfolio.

The point of this discussion may at a swift glance not be readily apparent; a brief preview of the consequences should provide some degree of tangibility:

Analyzed in a holistic framework, the rational for existing and possible future currency-hedged bond investments is seriously questioned which

  • at the macro level potentially renders one of the largest post-crisis cross-border capital flows as much less profitable, if not outright negatively carrying. The latter option substantially increases the possibility of (at least partial) liquidation of such investments, with considerable upward pressure on bond yields until a new equilibrium is found.
  • at the micro level challenges the portfolio composition of the institutional investors allocating clients’ money. Should such investments indeed prove negatively carrying, the clients will absorb losses. These would arguably not be of significant notional scale, but are of significance in that they represent unnecessary opportunity costs which could have been avoided by a different asset allocation.

One final point to settle before commencing with the main body is the level of abstraction at which this problem should be addressed. As with many aspects of financial markets, the underlying concepts involved are quite straightforward if approached incrementally; a nonlinear narrative paired with overdoses of jargon can, however, have the opposite effect. For this reason, the largest portion of the post will be quite detailed; it will put the issue of FX hedging in a broader context and dissect the variables affecting currency-hedged investments individually. This requires some time, so in addition there is also a technical summary for the jargon-savvy reader at the beginning, concisely outlining the main points in ~200 words.


Outline:

  • Why hedge and who hedges
  • Hedging instruments: three views (physical vs. FX forwards/swaps vs. cross-    currency swaps)
  • Dissecting return variables of currency-hedged bond portfolios (in a stylized setting)
    • cross-currency basis
    • term premia
    • libor/swap spread differentials
    • credit risk premia
  • the real world: the Japanese case

Technical summary:

A bond portfolio currency-hedged with short-term FX forwards/swaps is structurally similar to a repo-funded bond portfolio; the only difference is that instead of a repo rate, the funding rate is based on a Libor benchmark, which is nudged up (or down) by the respective cross-currency basis. As with any trade funded at a short-term floating rate and exposed to a fixed-rate instrument on the asset side, the key PnL driver (when held to maturity) is not the differential between the two rates at initiation, but the realized term premium at trade conclusion. Term premia are notoriously hard to forecast; most model estimates for the U.S. during the last number of years however produce negative values, implying losses on currency-hedged investments in the sovereign space. Negative cross-currency bases and disadvantageous Libor–OIS (or rather Libor – T-bill) differentials do their part to further diminish potential returns. Most players are willing to accept some degree of credit risk (usually in the corporate space down to ~A-rated issuers), which acts as a counterbalance, improving potential returns. Still, with credit markets offering limited amounts of spread pickup and issuers already quite levered at this time in the cycle, it appears hard to generate substantial – if any – alpha by this type of investment. Continue reading “FX-hedged yields, misunderstood term premia and $1 tn of negative carry investments”

FX-hedged yields, misunderstood term premia and $1 tn of negative carry investments