While May was a strange month for U.S. Treasuries, it was even more so in the more obscure corners of the global currency markets. The yen moved aggressively up against the greenback — likely temporary due to recent BOJ actions — while the Brazilian real, South African rand and Indian rupee moved aggressively down against the dollar.
The moves in Treasuries and currencies are (somewhat) related. Right now, we have market expectations for rising real interest rates in the U.S., which is causing major investors to rethink their intermediate-term outlook for the U.S. dollar.
In the short-term, it should not be surprising to see the yen firm up a little against the dollar given how much it has come down in the past six months. The yen on the USDJPY cross rate moved from 103.74 to as low as 93.98, while higher-yielding currencies like the Brazilian real and South African rand moved from 2 to 2.17 and 8.90 to 10.24, respectively, since early May.
The Carry Trade
As the yen is (temporarily) rising aggressively against the dollar, the real, rand and others are falling against the dollar and falling even more aggressively against the yen. When such an aggressive realignment happens against major higher-yielding currencies, only one cause comes to mind — unwinding carry trades.
A carry trade by definition is using funding that costs less to buy an asset that yields more and capture the yield spread. It is popular with various kinds of bonds, but it happens a lot with currencies, too. If the yen is a currency that has a short-term target rate of 0.1% imposed by the BOJ, wouldn’t it be nice to sell yen to buy Brazilian real that has a short-term target SELIC rate of 8% and capture that spread?
While it sounds like a no-brainer, in reality only major institutional investors can do such carry trades because there are hedging risks, as the recent yen move illustrates, as well as taxes on short-term capital inflows that deter such actions in Brazil’s case. At a time when institutions sense danger on the horizon — like weakening high-yielding currency fundamentals or the potential for rising funding currency interest rates, be it for the dollar or the yen — they head for the carry trade exits en masse, just like they are right now.
In reality, neither their target currency fundamentals nor their funding currency interest rates have to rise. Only the perception that those are changing or might change soon is enough to cause a violent short-term move in the currency markets.
Company Currency Risk
Since individual investors are largely left out of the currency carry trade business, we should also discuss how the aforementioned currency moves affect their stocks.
ADRs carry currency translation, as those trying to capture the aggressive moves in the Nikkei have recently found out, while the business of all major U.S. multinationals is also substantially affected. The bulk of Coca-Cola’s (KO) and McDonald’s (MCD) sales are outside of the U.S., which have been a great help to their profits during the past 10 years. If the dollar goes up substantially from here, naturally their profits would be hurt … but how much?
Profits at Philip Morris International (PM) might be hurt even more as virtually all of it sales are outside of the U.S. and thus all carry currency risk. Since PM has been doing this for a long time and its business is entirely outside of the U.S. (while Altria’s (MO) business is entirely in the U.S.), I thought it was interesting to see what the company’s own projections are for its currency risk in its latest 10-Q filing:
“On April 18, 2013, we revised, for prevailing exchange rates only, our 2013 full-year reported diluted EPS forecast to be in a range of $5.55 to $5.65, versus $5.17 in 2012. Excluding an unfavorable currency impact, at then prevailing exchange rates, of approximately $0.19 for the full-year 2013, reported diluted earnings per share are projected to increase by approximately 10% to 12% versus adjusted diluted earnings per share of $5.22 in 2012, unchanged from the constant-currency earnings per share forecast disclosed on February 20, 2013. The $0.19 in unfavorable currency for the full-year 2013, based on then prevailing exchange rates, represents an increase of $0.13 compared to the $0.06 of full-year unfavorable currency impact previously disclosed on February 20, 2013. This forecast includes a one-year gross productivity and cost savings target for 2013 of approximately $300 million and a share repurchase target for 2013 of $6.0 billion. The bulk of our earnings per share growth is expected to occur in the latter part of the year, and we anticipate a particularly strong fourth quarter.”
I like Philip Morris’ intermediate-term fundamental outlook given rising cigarette volumes, which contrast greatly with total U.S. cigarette volume that has been shrinking since 1981. So a 19-cent hit to EPS because the dollar might go up does not bother me in this case. Of course, PM could be wrong and the dollar could rally more, but the major point is that a rallying dollar should not be a cause to reject the shares of a strong company executing on a sound business plan.
In the end, no one other than company management really knows what the FX risk is in the company’s operational performance. An SEC filing like a 10-Q gives us only a snapshot at the end of the quarter while a lot can change with FX futures and forwards until the next quarterly filing. If PM management chose to — and I do not believe that they have any intention to do so — it can have its operational performance hedged in a way to benefit from a rising dollar. That would require certainty in the direction of FX markets that no one can provide, even though the hedge is technically possible.
What is fascinating to me from all this FX volatility in 2013 is how few investors were prepared for a dollar and a Treasury yield spike, and the resulting selloffs in many commodities.
Somehow, many people assumed that quantitative easing in the U.S. would mean a one-way street lower for the greenback, not understanding that the money “printed” by the Fed never really left the Federal Reserve Bank of New York and is still sitting there in the form of banking system excess reserves.
As I understand it, this gigantic warehousing of excess reserves is Bernanke’s grand contribution to momentary economics and (for the time being) successful attempt to releverage the U.S. economy to get back to its borrow-and-spend mode.
If excess reserves were a river, the Fed’s QE operation is like the constant and intentional filling up of a large water dam in order to lower long-term interest rates and fund the U.S. government. Like a dam can produce a lot of electricity, the Fed is producing economic growth with its federal government deficit funding and lower-than-otherwise-would-be long-term interest rates. Like a dam wall, interest paid on excess reserves is used to prevent this monetary liquidity from flowing into the financial system in a destructive manner.
Although Bernanke is successful for now, what happens when the dam reaches its limit?
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates holds positions in KO, MCD, PM and MO for some of its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.