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July 30, 2004
GLOBAL MARKETS
TREASURE HUNT
Global Business Opportunities
in Financial Market Risk Management
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Global Markets Group
Published by UBOC Global Markets Group. This report has been
prepared from sources we believe to be reliable. We make no claim as to its accuracy. Any opinions expressed are not that of
UBOC and/or its affiliates. UBOC may act as principal or as agent in a security mentioned. All prices and rates are subject to
change without notice.
Short-term Rates (1/1/00~): start of tightening cycle
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
Jan00
Union Bank of California
3M LIBOR
Fed Funds Target
Discount Rate
Fed expected to raise Fed Funds target by 25bp on
8/10. Greenspan’s optimism for real or not? (p. 4)
Investors may want to have short maturities: consider
Auction Rate Notes. (p. 3)
Prime Rate
US$ back stronger again as Greenspan gives upbeat
Testimony. (p. 2)
Jul- Jan00
01
Jul01
Jan- Jul02
02
Jan- Jul03
03
$/¥ (1/1/03 ~): stronger US$
Jan- Jul04
04
Stuck with a high coupon swap but want to refinance?
Consider an Extendable Swap. (p. 2)
FX market waiting for Fed decision and pace of future
rate hikes to determine course of US$. (p. 5)
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Foreign Exchange - Bernard Tsui (213-236-6943)
Interest Rate Derivatives – Jeff Hiraishi (213-236-6731)
Securities Trading & Sales – Jeff Katz (213-236-5097)
Editor - Tomoko Iwakawa (213-236-6488)
Distribution requests for Treasure Hunt may be directed to Karen Walton on (213-236-4253)
1
GLOBAL FX:
Waiting for the Fed
DERIVATIVES:
Refinancing loan with an Extendable Swap
The US$ was shaken out of its summer malaise
on recent upbeat comments by Fed Chairman Greenspan who affirmed
that the US economic recovery is firmly on track. In his Congressional
testimony, Greenspan predicted that growth would accelerate in the IIH ‘04
and into ’05, maintaining that the timetable for rate hikes was intact, affirming
the Fed’s most recent statement that rate hikes would be a “measured” pace.
Earlier this month, however, the jobs report came in at +112,000 for
June, well below the several previous months reports above +200,000. June
Retail Sales also had the sharpest drop in 16 months, while June Industrial
Production fell 0.3%, marking the first drop in 4 months. The rash of weaker
economic reports led many to reevaluate the health of the US economy,
resulting in the €/$ to rise to a 4 month high above $1.24/€.
In light of weaker economic reports, market participants were caught
off guard by Greenspan’s upbeat comment. The US$ quickly reversed course
after his statements on prospects that the Fed’s timetable for rate hikes was
intact. Adding to the US$ gains, Greenspan’s outlook for an economy
gathering momentum was buttressed by July Consumer Confidence which
came in a stronger +106.1 from +102.8 the previous month. In response, the
€/$ fell to $1.2031 and the ¥ weakened to above ¥111/$.
Meanwhile the euro-zone remains mired in sluggish growth. The
European Union revised down its Q3 growth forecast to the 0.3-0.7% range.
Growth remains anemic; Q1 GDP grew 0.6%, up from 0.4% in previous
quarter. The European Central Bank has resisted calls to cut interest rates to
spur growth citing inflation concerns. Inflation rose 2.4% in June, largely on
the back of rising energy costs. With inflation becoming a growing concern,
markets are instead speculating that the ECB’s next move could be towards
raising rates as early as September. The ECB’s official stance towards
interest rates is presently neutral.
In contrast, the UK has been grappling with reining in strong domestic
conditions. The Bank of England has raised rates 4 times since last
November bringing the Base Rate to 4.5%, which made £/$ rise to 5-month
highs at $1.8769/£. With unemployment at the lowest levels since 1975 and
June inflation at 1.6%, market is anticipating another BOE rate hike soon.
Similarly, Japan appears solidly on track towards recovery. The
much-anticipated Tankan survey of business sentiment soared to 13-year
highs. The government has raised GDP estimates to 3.5% for ’04, the
strongest growth in 3 years. The Bank of Japan has pledged to maintain
its zero interest rate policy that has underpinned the recovery.
With further rate hikes in the US looming, the FX market is taking
cues from the Fed and attention is once again focused on the US economy.
The US$ appears set for further gains in the event the Fed continue to
raise interest rates. Market participants will be closely scrutinizing US
economic statistics to determine how soon and when the Fed will act.
One of the challenges before borrowers in the current market is
what to do with their existing swap(s) when deciding to refinance their
loan. Based on an imminent view that the Fed will continue to follow through
on their tightening cycle, combined with the need to borrow more money for a
longer period, customers are looking at different strategies in restructuring
their loan/swap.
Since the existing loan is on a floating rate basis, the customer can
terminate the loan at the end of the period cycle and refinance it without a
prepayment cost. However, if there’s an existing swap, the customer can; 1)
terminate the swap, cash settle it (in the money, or out of the money), and
execute a brand new swap; 2) leave the existing swap in place, and execute a
new forward starting swap; 3) execute an Extendable Swap.
Extendable swap – Definition: terminate an existing swap and
embed the gain or loss into a new longer tenure swap. If the swap is “in
the money,” customer can terminate the swap and embed the monetary gains
into the new swap to “buy down” the fixed rate. If the swap is “out of the
money,” customer can terminate the swap and embed the loss into a slightly
higher fixed rate, without having to pay a swap prepayment.
Economically, there’s no advantages with the Extendable swap
because your gain or loss will still be realized, however, it’s more of a
convenience factor for the client because there’s no need to cash settle
anything (payment to client if in the money, payment to UBOC if out of the
money), or having to monitor two separate swaps at the same time. In reality,
the prepayment gets paid over time.
Example: Existing $5MM (bullet) swap maturing on 8/1/05 at 3.00%
1) The customer can decide to prepay the original swap for $25K, and
execute a new $5MM swap from 8/1/04 – 8/1/09 at 4.40%. (2 transactions)
2) The customer can leave the existing $5MM swap (8/1/05 maturity) at
3.00%, and execute a new $5MM forward starting swap from 8/1/05 –
8/1/09, at 4.90%. This would give the client an average rate of 4.52% for
the next 5 years. (Need to monitor 2 swaps)
3) The customer can execute a New Extendable swap where the customer
terminates the original swap, embeds the $25K prepayment, and extend it
out to 8/1/09 at a rate of 4.52%. The $25K prepayment, equates to a 12bp
premium. (1 transaction)
David Rhee
Jeff Hiraishi
2
weak labor report most likely will force yields back down to test the
recent lows. Once again, participants will probably pause before
buying more bonds initially at the test of the low recent yields. A strong
report and one can expect new highs in bond yields in anticipation of
more rate hikes to come. From the FOMC meeting, investors should
pay attention to whether the Fed acts, by how much they raise rates
and their comments. Paying attention to this should give investors a
read as to the near term direction of the market.
SECURITIES TRADING & SALES:
Investors Firmly Believe in Higher Rates
After reaching new recent high yields in June in anticipation of
the Federal Reserve raising rates, bonds began a descent in yield,
post the actual announcement of the rise. This downward trend
continued into July, reaching its floor in mid-month. It is a common
phenomenon in the market to “sell off” in anticipation of news, only to
“trade up” on the fact. In addition, with all participants believing the
Fed was about to raise rates, speculative shorts had already been set
for some time, pushing yields higher. With bond prices not going
lower after the announcement, those holding short positions bought
bonds to lock in their profits, thus creating a bond rally.
With the expectation for rates to rise and important
announcements to come soon, investors may wish to keep their
funds in relatively short maturities.
Should investors find
themselves with high excess cash balances not needed for some
time, investors may find an attractive avenue with Auction Rate
Notes. This security has become very popular especially among
corporations due to their high short-term return, float feature, availability
of high credit rated issuers and put feature on coupon re-set dates. In
this rate rising expectation environment, this product allows the investor
to follow rates as they rise, without placing their investment in a very
short-term maturing security offered at a lower return. Depending on
the structure of the Note, these securities are yielding today, anywhere
between .80% (tax free) and 1.75%.
Interestingly enough, after the Fed rate rise and the market
retracement of its June sell-off, participants received several
pieces of bearish news on the economy. The labor report, Retail
Sales, Housing Starts, Building Permits, the ABC Consumer
Confidence Index and Leading Indicators reported in July all were
weak or weaker than what economists had expected. The market,
however, failed to “buy in” to the notion that the economy would be
unable to sustain its recent momentum and that yields on bonds
should go even lower than the post-Fed rate rise announcement
rebound. In other words, bonds held their yields and did not fall more.
These reports were followed by Greenspan’s remarks before
Congress suggesting that the bearish news were just a “pause”
in the economy and that not only would the economy sustain its
momentum, but that the Fed was prepared to raise rates further.
This lack of bond price follow through, coupled with Greenspan’s
comments provided bond speculators the comfort to “re-set” their
speculative short positions again which commenced bond yields to
slowly rise again. Adding momentum to this retreat in bond prices
since Greenspan’s comments have been favorable reports on Jobless
Claims, Existing Home Sales and Consumer Confidence. In sum,
using the 2-year maturing U.S. Treasury Note as a benchmark, its
yield reached a low in July of approximately 2.50%; down from its
flirtation with 3% just prior to the Fed rate rise announcement. Now,
the 2-year Note has “retraced” half of it recent move and has settled in
at 2.80% (see chart on right).
2 yr T-note yield: since 1/1/04
The next watershed events that participants should be
focusing on will be the August labor report and FOMC meeting. A
Jeff Katz
3
7/28/04
INTEREST RATE OUTLOOK
Tomoko Iwakawa
Over the 6/30 Federal Open Market Committee, Fed decided to raise rates by
25bp, maintained a ‘neutral’ stance on both growth and inflation in its
accompanying Statement while confirming ‘measured tightening’, despite a rate
hike for the first time in 4 years. The market is expecting another 25bp rate
hike over the August 10 FOMC, which would put the Fed Funds target at
1.50%. Focus remains yet again on the Statement and its bias.
Most recently, over the Humphrey Hawkins semi-annual testimony, Fed
Chairman Greenspan had an unambiguously upbeat assessment on the US
economy, such that it made the market react in thinking about any possibility of
an even faster pace of tightening than ‘measured’. He said that, “if inflation
pressure is stronger than expected, a more aggressive tightening would ensue”,
while ”the considerable monetary accommodation put in place since 2001 is
proving increasingly unnecessary”. He also mentioned that, “the recent slowdown
in consumer spending should prove short-lived” and “the economy should grow
strongly”. Other Fed officials have reiterated that view implying that there is still
considerable distance for rates to rise before reaching ‘neutral’, which is expected
to be another 200 – 350bp higher than today’s levels.
This optimistic growth and low inflation outlook Is based on “strong household
balance sheet” (despite low consumer savings and high debt), i.e. a result from
higher net worth derived from higher asset prices such as real estate and stocks.
The Treasury market sold, while equities strengthened, and so did the US$.
The risk, however, is if asset prices turn around, household balance sheet will also
be vulnerable. Other impediments to recovery may be the record high crude oil
prices ($43.05/barrel) and possible geopolitical risks, weaker-than-expected labor
market report (due on Aug 6), etc. So it is no wonder that the Fed is trying to
manage market psychology in the midst of a challenging tightening cycle,
which may leave some reservations when reading the Fed…..
DJIA (1/1/2003~ present)
10 Year US T-note (1/1/2003 ~ present)
Crude Oil (1/1/2003 ~ present)
Gold Prices (1/1/2001 ~ present)
4
FOREIGN EXCHANGE OUTLOOK
By David Rhee
UBOC FX ADVISORY SERVICES
EUR/USD CHART
Foreign Exchange Market Focus
The USD got a much needed shot in the arm from Fed Chairman Greenspan who’s rosy
assessment of the US economy helped save the dollar’s suffering from a muddled
economic picture at home. A widely anticipated and already priced-in 25 bps rate hike to
begin the month had little effect on the dollar. Additionally, prospects for an aggressive
rate tightening cycle appeared to fade with mixed the economic reports which led many to
scale back the timetable for Fed rate hikes. In response, the dollar fell to 4 ms. lows
against the euro above $1.24 until Greenspan’s comments helped lift the dollar. In
testimony before Congress, Greenspan predicted growth would continue to expand and
affirmed that gradual rate hikes were still on track.
Review (USD/JPY)
July
Review (EUR/USD)
USD/JPY
107.53-110.31
The yen settled into narrow ranges despite continuing
signs of growth in Japan. The Japanese government
doubled its GDP forecast to 3.5% for the current fiscal
year—the highest in 3 years.
The Tankan survey
highlighting business confidence came in the highest in 13
years.
Favorable business is underpinned by a firm
commitment to continue its ultra loose, zero interest rate
policy. The yen also overcame political obstacles when
the LDP managed to hold its ruling coalition together
despite losing seats in Parliamentary elections.
Review (Other Currencies)
July
AUD/USD
0.6963-0.7345
USD/CAD
1.3055-1.3343
The fortunes of the one time high yield plays, CAD and
AUD, have risen and fallen on interest rate prospects in
the US; soaring when rate hikes appeared to wane and
subsequently falling when Greenspan provided an upbeat
outlook on the US economy. The CAD, a commodity
currency, also benefited from high oil prices. Both the
CAD and AUD are expected to continue to raise rates in
response to strong domestic conditions in the coming
months.
EUR/USD
GBP/USD
July
1.2084-1.2460
1.8113-1.8765
Actual Previous
-The euro rose to 4-ms. highs against the dollar despite
lackluster economic conditions. The European Union revised
down its Q3 growth forecast to 0.3%-0.7% q/q. Despite the slack
economic conditions, the ECB has affirmed a neutral monetary
policy stance despite calls for the ECB to cut rates.
-The GBP rose to 5-ms. highs on strong domestic conditions but
subsequently gave up its gains on signs that rate hikes are
taking their bite. Notably, the four interest rate hikes since
November are cooling the once red-hot housing sector. Most
recently, the BOE held rates unchanged on cooling home prices.
Outlook
August
In testimony before Congress, Greenspan predicted that
growth would accelerate in the second half of this year as
the economy gains momentum and continue into next
year. His comments caught many market participants,
who had pared back rate hikes estimates based upon
mixed economic data in the US, by surprise. The dollar’s
recent comeback is based upon the sentiment that the
Fed will continue to raise rates based upon this steady,
gradualist approach. Market participants are anticipating
the Fed’s next meeting on Aug 10.
-
5-
Jobless rate
Non-farm payroll (000)
Trade balance ($ bln)
PPI
CPI
Retail Sales
Industrial Production
Capacity Utilization
5.6%
+248
-46
+0.8%
+0.6%
-0.5%
+1.1%
77.8%
5.6%
+346
-42
+0.7%
+0.2%
+0.2%
+0.8%
77.1%
GDP
+3.9%
+4.1%
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foreign exchange products (except FX spot transactions) are
available only for eligible swap participants as defined in 17 CFR
Part 35. This report has been prepared from sources believed to be
reliable but it is not guaranteed to be accurate. Any opinions
expressed are not those of UBOC or its affiliates. All prices, rates
and other information are subject to change without notice.
UBOC and other persons may make use of or act on the
information contained in this report prior to its distribution.
UBOC may act as a principal or agent with respect to any security
or other investment product mentioned in this report.