Wednesday, November 21, 2007

Managing Your ADRs: The Case of the European Financials

Taking a look at the yield curve in the UK, the yield on the 10-year gilt recently rose above that of the 2-year gilt for the first time since Q2 of 2006 as the yield curve shows signs of normalizing. The spread between the 2-year gilt and the 2-year swap has, over the past week, risen to its highest level since the early 1990’s as market participants move away from corporate debt and into sovereign debt. Similarly, 5-year credit default swaps on UK financial companies such as HBOS, HSBC, Lloyds, and Barclays are currently trading at lifetime highs, breaking above previous highs set in late August/early September. Set in an atmosphere of sharp volatility, these developments, along with investor’s ‘jittery’ behavior suggest that the general market consensus is that the long arms of the sub-prime crisis are still bent at the elbows.

Over in Germany the spread between 2-year swaps and the 2-year bobl has also reached its highest level since the 1990s. While credit default swaps are only above their August levels in some cases, namely Allianz, Bayerische Hypo, and Deutsche Bank, they are certainly on the rise. As one might expect, a flight to sovereign instruments away from corporate debt, as well as a rise in credit default swaps can be observed in most major European countries.

The data paints a simple picture. Over the coming weeks and months volatility is likely to continue, especially within the financial sector, as market uncertainty seems to be on the rise. While everyone has their own approach, it may be best to throw a cautious eye at the European financials. Better safe than sorry.

Tuesday, November 20, 2007

FX Intervention A Possibility This Week

Has the last straw been drawn? Do current market conditions finally warrant FX intervention on the weak US Dollar? Could we see FX intervention during the thinned holiday week?

Answers to these questions may have come today in the form of an article published in the Al-Riyadh newspaper. According to the article, which cites a GCC official, Saudi Arabia may have started studying a revaluation of the Riyal. The official said that the Gulf States wish to move towards a currency basket, adding that the UAE and Qatar are amongst the states that are keen to revalue their currencies. The official noted however that there is also a strong possibility that Saudi Arabia will maintain its current exchange rate policy, but added that, if the Dollar continues to weaken, other Gulf States will not stand idle even if Saudi Arabia does. The comments quickly prompted the Dollar to decline to new post World War II lows against the Swiss Franc below the 1.1100-level, and push the Euro to fresh all-time highs against ardoun1.4760.

While the Dollar’s decline has been focus for the past couple of months there has been a slight change in rhetoric around the Dollar decline. While the French were quick to complain about the effects of the weaker Dollar on business, German companies and officials have recently started indicate that the Dollar is approaching levels that will impact German exports, and possibly the German economy. A slight shift in the rhetoric of central bankers on the topic has been observed as well. While over the past few months many central bankers reiterated the G-7 communiqué statement on currency, which states that volatile moves in FX are undesirable, there has been a shift away from the communiqué’s statement to the phrase “brutal FX moves”. While “brutal” is still undefined by central bank officials one might find the term “brutal” as a suitable description for the Dollar’s recent decline.

Thin market conditions prompted by the Thanksgiving holiday in the US this Thursday may provide the perfect market environment for FX intervention. Thin markets would enable the intervening party to maximize its impact on speculators, improving the chance of cementing a trading range. According to Don Wilcox at the Helia Resources Center, the price pattern in the Eur/Usd is similar to that of the Usd/Jpy in the late 1990s when central banks coordinated intervention when the pair breached the 147.00-level in June 1998.

Historically, central banks have been somewhat creative in such situations. With the recent aggressive rhetoric towards China regarding Yuan overvaluation intervention could be coordinated via the Eur/Jpy. The move would demonstrate a unified voice amongst central banks, hence killing two birds with one stone, namely intervening on the weak Dollar, and sending a message to China. While nothing is certain, the market current environment presents central banks with a grand opportunity to make a move. The question remains, does market activity warrant it?