For 2015, we see higher volatility and numerous opportunities in the rates and currency markets, particularly in Asia, where the difference in central bank regimes and policy action can be quite pronounced. Looking around the globe, there are expected rate hikes in the US and the UK on the one hand yet quantitative easing from the ECB and BOJ on the other; further slowing in China is expected versus optimistically anticipated growth in India; and there are important implications of lower energy prices and the specter of deflation. In Asia, which remains the largest driver of global growth, most governments and central banks face arguably their most challenging year since the crisis of 2008-2009. These challenges can largely be seen through three different, albeit interconnected themes that also provide opportunities.
The success of Abenomics in Japan so far is open to debate but there is no doubt that the massive easing operations by the Bank of Japan have benefitted Japanese exporters via the cheaper yen and created problems for their export-driven competitors in South Korea, Taiwan and even China. The recent fall in the Euro only exacerbates these pressures. Both China and South Korea have capital account controls, allowing them some control on the level of their currencies but potentially creating artificial bubbles that, as we have seen in Switzerland, can create imbalances and issues in the future. In South Korea, the growing level of household debt makes it difficult for the Bank of Korea (BoK) to cut rates further in order to weaken their currency (which could create a bubble) in spite of the pleas of the chaebols. In China, competing pressures (see below) can make direct management of the relative currency valuation challenging. However, these problems and constraints for policy makers create opportunity for hedge funds in exploiting inconsistencies in interest rate curves and trends in currencies. For instance, there are numerous arbitrage opportunities in the South Korean NDF (non-deliverable forward) curve that can be exploited, particularly as the big exporters repatriate capital at certain key points in the year.
The China Conundrum
Policy makers in China face a multitude of challenges. On the one hand, the central government is committed to reform and the eventual opening up of the current account; on the other hand, fears of capital outflows and domestic issues will likely tie their hands. While historically the Chinese government has had active policies to stem the appreciation of the currency, the need for a lower currency valuation is not as pronounced as it once was. Exports are a lower contributor to GDP than in the other East Asian economies; also, the price of commodity imports has come down. However, in early 2014 the People’s Bank of China (PBOC) surprised the market by widening the CNY trading band, pushing the onshore currency lower against the dollar. With domestic interest rates moving lower and more liquidity entering the market it is possible this will happen again – a further blow to the popular carry trade (using Qualified Foreign Institutional Investor (QFII) quota to take advantage of higher onshore rates and the appreciating trend of the currency). The path and priorities of policy makers remain uncertain and are in flux; this uncertainty has created volatility and trading opportunities.
Meanwhile, the offshore Renminbi market, CNH, is growing in size and opportunities exist both in the forward curves and in the spread with the onshore CNY. Interestingly, some Chinese corporates are now funding offshore in CNH through the Shanghai Free Trade Zone; as more FTZs open up it may lead to a convergence of rates. There are now more ways to access these markets with the expansion of the R-QFII (Renminbi-denominated Qualified Foreign Institutional Investor) scheme, the FTZs and an increased number of offshore trading centres: this should present investors with an increasing opportunity set. These would include arbitrage trades around the CNH/CNY spread (and its likely convergence) as well as option trades in CNH around the CNY daily fixing.
Resilience in the Emerging Markets
Asia’s emerging markets have traditionally moved in lock-step with the direction of global emerging markets. More recently we have seen much more dispersion in returns between the region and the rest of the world. While lower commodity prices are hindering some countries globally, lower energy prices have proved beneficial for all the regional economies apart from Malaysia. Lower energy costs have allowed the new reformist governments in India and Indonesia to reduce and abolish fuel subsidies and rein in their current account deficits. Lower energy costs have also spurred on the strength of domestic consumer demand which has supported the currencies of the Philippines and even Thailand during the recent strong trend of dollar strength.
The key question hanging over these markets is what happens if and when the US raises rates: will there be a flood of outflows of capital, particularly from the government bond markets? In Indonesia, for example, foreigners hold over 30% of the outstanding government dollar-denominated paper. The implications of lower inflation across the region too suggests more volatility ahead – the Reserve Bank of India in New Delhi recently cut rates for example.
For hedge funds focusing on Asia, the policy uncertainty, unclear interest rate environment and resultant expected higher volatility should offer attractive opportunities both in relative value and directional trades. Potentially competitive devaluations, lower commodity prices and inflation, the push for reform not only in China but also in Japan, India and Indonesia, and the prospect of higher rates promise an attractive environment for investors in the months ahead.
David Walter is a Director in Portfolio Management. He serves in PAAMCO’s Singapore office as Head of Research for Asia and he is a member of the firm’s Strategy Allocation Committee.
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