Quick analysis on Russia and the Ruble

We heard lately that Russia intends to continue to operate in a floating regime concerning its exchange rate despite a [two-quarter] sell-off of the currency. USDRUB is now trading at an all-time high of 42.85, and we are asking ourself how far we could go…

If we refer to last week’s chart on Oil Breakeven prices (see article Chart of the day: Oil Breakeven prices), we can see that Russia needs oil price at around $100 (per barrel) in order to be ‘breakeven’, which is approximately $15 more than the current level (COX4, which corresponds to Brent November 2014 futures contract, is now trading at 84.50). Therefore, this is Putin’s first issue as the country’s Government budget deficit will widen to ‘scary’ levels if the situation persists.

In addition, with a current annual core inflation rate of 8% (September), the central bank (CBR) cannot let its currency depreciate for so long as the country will experience high inflationary pressures in the medium term (2nd issue).

However, has the country got sufficient Foreign Exchange reserves in order to defend its currency in the medium term?

According to official figures, Russia’s International Reserves (split between Foreign exchange reserves and gold) decreased by $73bn to 443.8bn (USD over the past year (and are down $155bn since historical high of 598.1bn USD). The country holds 1,149 tonnes of gold (With a bit more than 10% of the total reserves, Russia is the 6th biggest holder of gold in the world) and invested $118.1bn dollars in US Treasuries. In addition, by signing new deals with China (Last May, 30-deal of $400bn to jointly produce and deliver 38bn Cubic meters of natural gas), the CBR holdings of CNY have started to increase drastically (not sure about the figure yet). As a reminder, Russia signed a three-year swap deal of 150bn Yuan a couple of weeks ago that aims to make bilateral trade and direct investment (therefore, bypassing the US Dollar). China is already Russia’s largest trading partner, with an annual turnover of $89bn in 2013. According to PM Medvedev, this figure could increase to 200bn USD by 2020.

Based on those figures, the country is quite safe and the central bank has strong capital to intervene in the market if it judges the situation unsustainable (unlike Venezuela or Argentina). However, where is the high?

Quick Chart on USDRUB:

As the pair trades at an all-time high, I like to look at the Fibo retracements to find out where I can set up the next resistance on the pair. Based on the 23.0520 – 36.5590 retracements as you can see it on the chart, the next resistance on the topside stands at 43.35, which corresponds to half of the previous range (6.75 RUB approx.).


(Source: Reuters)

ECB dilemma: Whatever it can…

As you know, the Fed eventually stepped out of the market with its last POMO of QE4Ever yesterday (the NY Fed revealed that it monetized $931mio of bonds maturing between 2036 and 2044); normalcy returns today for the US. However, the game is starting in Europe with the ECB that started its covered-bonds purchases last week (a mere 1.7bn EUR according to Bloomberg). And there is more coming: ABS purchases, second round of T-LTRO on December 11th, corporate bonds in the secondary market and eventually sovereign bonds if needed.

Remember the ECB’s most important chart (see below) right now, the 5Y5Y forward swap rate, aka the preferred measure of medium-term inflation expectations. As a reminder, a 5year/5year forward swap represents a swap beginning in 5 year with a maturity of 5 years whereby counterparty pays fixed while the other pays a floating rate (3M EURIBOR for instance) on the nominal amount (for more details, see article Introducing the Swaptions (and IRS)).

As you can see it, the key number is 2 percent (or 200 bps). The rate moved below the threshold since the end of the summer and is now fluctuating around 1.80%.


(Source: Bloomberg)

It is the third time the ECB is intervening directly on the secondary market to ‘fight against’ deflation threat. As a reminder, annual inflation came in at 0.3% in September, far below the central bank’s 2-percent target (none of the countries below has an inflation rate as high as 2 percent). Moreover, officials reduced their inflation and growth forecasts to 0.6% and 0.9% respectively (from 0.7% and 1% respectively) for 2014 at the September’s meeting.


(Source: Eurostat)

After the 1tr EUR+ balance sheet expansion announcement (Draghi targets dimensions the central bank used to have in the beginning of 2012), there has been some talks that the ECB may struggle to find enough corporate bonds and ABS to buy (eligible as collateral). While EZ policymakers stated that there is approximately €600bn of eligible covered bonds, the market estimates that the ECB will only able to buy a small portion (a fifth?) of those assets. As banks benefit from covered bonds’ low risk weighs under Basel 3 rules, there is little chance they will sell it to the ECB and use the money to lend to non-financial institutions. Back in 2012, in its Covered Bond Program Round 2, the ECB struggled to meet its 40bn-Euro target and purchased only €16.4bn of those assets (see chart below from ZeroHedge). We will see how it will go this time.


(Source: ZeroHedge)

Any solution there?

We know Germans are not very keen on public QE (sovereign bonds), we call it the Draghi-Weidmann fight. Weidmann describes government bond purchases as a ‘dangerous path’, in addition to be forbidden (Article 123 on the Treaty of the Functioning of the European Union, the prohibition of monetary financing). Therefore, investors will closely watch the updates on the ABS and other corporate bonds purchases package, to see if the ECB can meet its goal.

After the ECB announced that 25 banks failed its third stress test (see details in Appendix 1), and that the cumulative capital shortfall among the 25 failures was €25bn (less than the €27bn reported in 2011), the ‘real’ scary figure was the €135.9bn increase in Eurozone bad debt to an outstanding amount of €879bn, which represents roughly 9% of EZ GDP (see details in Appendix 2, Bad debt is called NPE – Non-Performing Exposure). As ZeroHedge mentioned it in its last articles on the AQR/Stress test results, maybe the NPE should be the ECB ‘hot spot’. How long until Draghi monetizes those assets?

Appendix 1:


(Source: ECB’s website)

Appendix 2:


 (Source: ECB’s website)

Chart of the day: Oil Breakeven prices

After Saudi Arabia’s quiet talk on the fact that the country is comfortable with lower oil prices for an extended period of time, some countries are trying to find out some ‘measures’ to push up prices to ‘decent levels’. Brent November (2014) futures contract (COX4 Comdty)  is now down more than 25% since the end of June levels ($113 per barrel), trading slightly below $85.

We read that the Oil Storm is posing (and will pose) a problem for Russia (in addition to all the sanctions) and other OPEC countries. Therefore, we added today this chart (Source: DB) that shows you the Breakeven prices of all the big oil ‘players’.

For instance, Venezuela – OPEC member where oil revenues account for 95% of export earnings – called for an emergency OPEC meeting (next one stands on Nov. 27th) as current oil prices will hit its currency reserves. According to the chart below, the country needs a barrel at $120 to be breakeven (aka pay for its imports).

Let’s see what is the other countries’ breakeven…


Could we survive without QE? (Part II with US yields)

Last month, we wrote an article that summarized all the decision made by the US policymakers since GFC and the impacts as soon as the central bank was stepping out of the market (see article Could we survive without QE?)

We concluded that as soon as the Fed was ‘leaving’ the equity market and let it rely on fundamentals only, we saw sharp correction straight afterwards (See chart below: April—July 2010, July – August 2011, September-November 2012).


(Source: Reuters)

As we are ‘kindly’ approaching the last days of QE with the Fed stepping out of the bond’s market at the end of this month (October 28th), we thought it is a good time to give you an update on the current situation. And Guess what: this time is not different. Since the mid-September high of 2,019.26 (Sep 19th), the S&P 500 is down 7 percent and closed for the second consecutive session below the 200-SMA for the first time since November 2012. And the question we are asking ourself is: how far it could go? We don’t have a specific answer to that, but what we can tell you is that the Fed’s Officials are now realizing their mistake by expressing themselves on their ST monetary policy. Our thoughts have always been that Yellen [& Co.] should have let the market swallow a period without QE before considering raising its ST interest rate. Therefore, we saw at the last minutes (last Wednesday) a different tone, with policymakers suddenly jawboning about the US Dollar Strength (Yes, even the Fed is not comfortable with a strong exchange rate) and the fact that global slowdown could rise risks to US outlook. We expect the tone to remain neutral until the end of the year, therefore capping the appreciation of the US Dollar against all currencies. If the equity market continues to tumble, we think we can even see/hear a couple of dovish statements/conferences as the equity market is one of the most important index (with oil) for US policymakers.

If we have a look at the LT interest rates, the 10-year US yield is now trading at its 18-month low at 2.20%. Clearly, that shows the situation in the market is much more fragile than expected. Moreover, we added a similar chart as the S&P 500 but this time applied to the 10-year yield. We read and heard analysts’ recommendations on yields, and most of them are quiet bearish on Treasuries in the next months to come, targeting a 10-year yield at 3%. However, if we look at the chart below, we can see that each time the Fed stepped back of the bond market, LT yields contracted (March – November 2010, July-September 2011). And it looks like this time is [also] not different with the 10-year yield down 80bps since December’s Taper Announcement.


(Source: Reuters)

Quick update on FX positioning

The US dollar remains strong against all the currencies since yesterday, erasing little by little its post-minutes losses. EURUSD is back to 1.2660, the trend looks bearish and we would set our short term target at 1.2600. A bit late for bears (above 1.2750 was a perfect level to short the pair again), but there is little room for the downside. I’d play short EUR/GBP at 0.7900; a GBP strength relative to the Euro is inevitable, long-term bears just have to be patient for the 0.7500 retracement.

AUDUSD is back to 0.8700 (beginning of the week’s level), despite strong employment reports yesterday in Australia, with full time employment up to 21.6K in September (from 14.3 the previous month). We read that global growth worries will continue to weigh on the Aussie (with always the same story with China’s) slowdown, and the market clearly sees an Aussie trading at 80 cents against the greenback sometime in mid-2015. Next support on the downside stands at 0.8650 (we’ll see if it holds this time).

On the Yen side, we clearly think the bearish USDJPY momentum is not over yet and the JPY should continue to strengthen in the short until we see the big buyers-on-dips. The next support on the downside stands at 107.14, which corresponds to the lower band of the Bollinger Band (20,2x), followed by the psychological 107.

Bonus Chart before US opens:


(Source: Reuters)

Chart of the Day: FF rates futures

Back in September, we remember that Fed’s Officials raised their median estimates for the FF rates as some US policymakers had in mind a more aggressive path concerning rate hikes. Based on the Fed’s dot plot (see Dollar pause, but when?), the estimates were FF rates of 1.375% and 2.5% by the end of 2015 and 2016 respectively.

Out of the 10 members of the board, two hawks – Philadelphia’s Plosser and Dallas’s Fisher – and disapproved the September’s statement as both of them have been critical of the Fed’s money-pumping strategy and are concerned that a long period of low interest rates could generate inflationary pressures (inflating asset prices, therefore destabilizing the financial markets).

However, after yesterday’s meeting, it is a different story. If we look at the STIRs futures market, we can see that the implied rates on the FFZ5 (White Line) and FFZ6 (green line) suggest that we will finish the next couple of years at 56bps and 1.56%, both down 20bps and 30bps since Sept 19th low.


(Source: Bloomberg)

Introducing the Swaptions (and IRS)

Today, let’s expand our finance knowledge and study what HF portfolio managers and IB traders ‘constantly’ look at: swaptions and the implied interest rate volatility. A swaption, as you may know, is an option to enter an IRS (interest rate swap) with a specified rate at no cost on a future date.

For those who are not familiar with swaps, let’s review quickly the structure of a ‘vanilla’ IRS.

An IRS is a bilateral agreement to swap a fixed rate of interest for a floating rate of interest. It is a derivative contracts (traded OTC) and it involves two counterparties (at least), the fixed receiver (receives a fix rate) and the fixed payer (floating rate). Unlike currency swaps, principal amounts are not exchange in an IRS ‘vanilla’ contract, and only the difference between the fixed and the floating rate is paid/received. In order to trade (hedging/speculating), you need four parameters: the date, the notional amount, fixed rate and the floating rate.

At the inception of the swap, the Net Present Value or the sum of expected PnL should add up to zero. If you type IRS on Bloomberg, you get to the swap manager page that you can see below.

Irs page

(Source: Bloomberg)

This contract is a 5-year IRS contract, 10Mio USD nominal between Leg 1 ‘Receiver’ and Leg 2 ‘Payer’. Therefore, with a fixed coupon of 1.796627% and October 10th as the effective date (date when interest begins to accrue, the first fixed payment will occur 6 months after that date (on April 10 2014) totalling an amount of 89,831.35 USD.

Fixed rate payment = Fixed rate * (Nb Days / 360 basis) * Notional

Nb of Days = 180, therefore Fixed Payment rate = 89,831.35 USD

On the other side, floating payments will occur every quarter, using the 3-month LIBOR as a benchmark (USD0003M Index). With a 3-month LIBOR trading at 0.23110% at the moment, the first floating-rate payment will occur on January 12 2014 (94 days) totalling an amount of 6,034.28 USD (same computation as the Fixed –rate payment replacing Fixed rate by floating rate). On page 9 (Cashflow, see appendix), you will see all the future payment details.

As all the future payment of Leg 1(Fixed Receiver) will rely on the evolution of the forward LIBOR curve, the swap valuation changes over time and therefore existing swaps become off-market swaps. For the curious ones, you can easily find the math equation on Internet, but the important thing to remember is that the payer (Leg 2) will start to lose money if interest rate started to fall unexpectedly.

Here we are now, back to swaptions and the 1Y10Y implied volatility that we like to watch quite a bit. There are two kinds of swaptions, a payer swaption (option to pay fixed-rate, eq. to call option with PnL rising if rates are rising) and a receiver swaption (option to receive fixed-rate, eq. to a put option with PnL rising if rates are falling).  If you buy a 1Y10Y 2% receiver swaption, it basically means that you have the right to receive a 2-percent rate on a 10 year basis starting in 1 year. Therefore, as we use the VIX in order to measure the market expectations of near-term volatility in the US stock market (S&P500), we use the 1Y10Y to ‘measure the temperature’ of the interest rate market. Quants use generally the Black’s model, a derived version of the Black and Scholes model (used for calls and puts), as a standard way of quoting prices on swaptions (two other methods of stochastic interpolation to model LIBOR forward rates are CEV and SABR.

If we have a look at 1Y10Y JPY implied volatility back in April/May 2013, we saw a surge in JPY volatility after the BoJ announced its QE plan which consists in doubling its monetary base within the next 2 fiscal years. As you can see it on the graph below, when the IR volatility (white/blue line) rose more than 60% in May, the ten-year JGB yield doubled and touched 1% (May 29th), while Japanese stocks dropped 7% the same day with a USDJPY down 3 figures.

Vol irs

(Source: Bloomberg)

Investors are still concerned about the volatility of the bond market which would force domestic financial institutions to reduce their JGB holdings. As a reminder, more than 90% of the Japanese government debt is hold by domestic ‘investors’, and 95% of this amount is held by institutional investors (GPIF, Japan Post Bank.. and of course the BoJ). Domestic banks and small/midsize financial institutions account for more or less 29% now, and still remember the ‘VaR shock’ of summer 2003 when 10 JGB yield tripled from 0.5% to 1.6% in June.

According to a study done by JP Morgan [a little while ago], a rise in the ‘JGB volatility’ increasing interest rate by 100bps would cause a loss of 10Tr Yen for Japanese banks. Therefore, if you are holding a LT position on USDJPY or any other asset (bonds, equities), you should pay close attention to the forward curve and the 1Y10Y implied volatility we just presented you.

Appendix: Cash Flows of the IRS

Cash flows

(Source: Bloomberg)

Happy October: End of POMO

As October is the Fed’s POMO – Permanent Open Market Operations – last month (as it is mine in Hambros), we will see how the equity market will deal in a period with no QE. The NY Fed released yesterday its purchase operations for the month of October (as you can see it below), stating that the central bank will buy approximately $10bn worth of Treasury securities on an outright basis.

Starting October 28th (the first day of the next FOMC meeting), the equity bulls will start to rely on fundamentals once again. As we say, will this time be different?


(Source: NY Fed)

The market has switched to a risk-off mode for the past couple of weeks with the S&P 500 struggling to trade above the 2,000 level. As you can see it on the chart below, the index (purple line)  is down 2.2% from its September’s high of 2,018.21 (Sep 19th) and AUD/JPY (black bar) is back below the 96.00 level (down 2% as well) and has been fluctuating within a 100-pip range for the past week.


(Source: Reuters)

Earlier this morning, both Germany and UK released a lower than expected manufacturing PMI, coming in at 49.9 (vs 50.3 expected) and 51.6 respectively (vs 52.5 expected). France reported its budget deficit forecasts for the next few years, and the government sees deficit falling to 4.3% of GDP in 2015 (from 4.4% this year), 3.8% in 2016 and eventually somewhere below  the 3% threshold in 2017 (optimistic?).

EUR/USD was little sold this morning after the macro news (1.2584 is today’s low) and is now trading back above the 1.2600 level. Cable hit its 1.6160 support, the 76.4% Fibo retracement of 1.6050 – 1.6526 (as we reported yesterday) before coming back to 1.6200.


(Source: Reuters)

This afternoon, the market will watch West fundamentals with Mortgage Applications, ISM Mfg PMI and ADP National Employment  in the US and Canadian PMI. We don’t see any major developments in the FX market as the market is now focused on tomorrow’s ECB meeting and Friday’s NFP.