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Global financial market sentiment turned more mixed in October. Central bank activity was somewhat muted as both the ECB and the Federal Reserve made few changes to their policy stance. The ECB reiterated its willingness to provide support to the Eurozone bond markets, but that support remains conditional on a country requesting aid from the European financial aid funds. The EU Leaders’ Summit made partial progress on the banking union, while differences over the implementation timeline and the treatment of the ‘legacy’ banking assets were highlighted during the meetings. Global economic data
has shown some tentative hints of improvement. Although China’s growth
slowed further in Q3, high-frequency data suggested a pick-up in
activity in September. U.S. economic data also showed positive signs,
notably in the housing sector, but the underwhelming tone of corporate
earnings has taken some steam out of the U.S. equity markets.
The improvement in European markets continued, albeit at a slower pace that during the previous month. Spanish ten-year yields fell by around 30bp to 5.60% as Spain avoided a credit rating downgrade to ‘junk’ status by Moody’s. Italian yields were down by around 20bp to 4.90%. Global equities have seen an up-and-down month, falling by around 1% overall. U.S. equities slipped by 2%, while ten-year Treasury yields were up some 20bp to around 1.80%. Expectations of further Bank of Japan policy easing weighed on the Japanese yen, which was the weakest G10 currency during the month. Commodity-bloc currencies were also lower, while the euro traded in a range. Emerging currencies were mixed, with Latin America generally underperforming relative to Asia and Eastern Europe. Americas U.S. economic data has offered some positive hints over the past month. Q3 GDP growth quickened to 2% q/q (annualized), in part thanks to a bounce in government spending. September nonfarm payrolls rose by 114,000 and the jobless rate fell to 7.8% thanks to a sizeable gain in the household measure of employment. There were further signs of a housing market pick-up, with September housing starts surging by 15% m/m to a four-year high, and homebuilder confidence rising for a sixth straight month. The September CPI quickened to 2% y/y both at the headline and the core. Following the announcement of further asset purchases in September, the Federal Reserve made no changes to its policy stance in October and made only modest revisions to its view on the economy.
The Bank of Canada surprised the markets by offering only a mild softening of its hawkish bias at the October meeting, suggesting that some moderate removal of monetary stimulus may become appropriate “over time”. The central bank appeared to downplay the recent CPI data, which showed core inflation slowing to just 1.3% y/y in September. Canada’s job market was firing on all cylinders in September, registering a gain of more than 52,000 jobs. In Mexico, economic data has been mixed as August industrial output slowed to 3.6% y/y but retail sales quickened to 4.8% y/y. In Brazil, the central bank cut its Selic rate by 25bp to 7.25%, and signaled that rates would remain at a low level for an extended period. Chile’s central bank left rates at 5.00% and, given a strong domestic economy, should keep policy steady for some time. The Chilean peso was nevertheless the weakest regional performer, falling by around 1.5%, while the Mexican peso and Canadian dollar slipped by around 1%.
Europe The euro and European markets more broadly were in a back-and-forth mode during the month as markets awaited the resolution of the Spanish and Greek uncertainties. The ECB October policy announcement had relatively limited market impact as the central bank left its Refi rate unchanged at 0.75% and repeated that the bond buying program would provide a fully effective backstop. At their October Summit, European leaders committed to a legal framework for a single Eurozone banking supervisor by the end of this year. While some differences remain regarding the speed of implementation, the banking supervisor is expected to become operational sometime in 2013. Eurozone economic data pointed to an ongoing economic contraction. The Eurozone October manufacturing PMI fell further to 45.3, while the services PMI rose slightly to 46.2. Meanwhile, Germany’s October IFO business confidence fell to a 2 ½ year low of 100.0.
The UK GDP jumped by 1% q/q (non-annualized) in Q3 with some help from temporary factors. Recent data, as well as comments from Bank of England policymakers, have tempered expectations of further easing by the Bank of England, helping the pound reverse its earlier losses. The Swedish krona was down 2% as Sweden’s central bank left its policy rate unchanged at 1.25% but said that it was “more probable” that rates would be cut rather than raised over the winter. The Hungarian forint was the strongest performer in Eastern Europe with a 3% gain as the government said it will scrap a plan to tax financial transactions at the central bank and pledged further budget austerity measures. Social unrest weighed on the South African rand which fell by 4.5% in October.
Asia Japanese economic trends have remained subdued. The Q3 Tankan survey showed the large manufacturers’ index falling to -3, while September exports slumped by 10.3% y/y. The Bank of Japan last left its policy stance unchanged but expectations are running high for a further increase in the central bank’s asset purchase target, and possibly other measures, at the next meeting. The Japanese yen slipped nearly 3% to a four-month low against the greenback. Meanwhile, recent Chinese data offered some tentative encouragement. The Q3 GDP slowed to 7.4% y/y, in line with expectations, but the September industrial output and retail sales both firmed, to 9.2% y/y and 14.2% respectively. Elsewhere in the region, Singapore’s central bank left its current policy stance intact, South Korea’s central bank cut rates by 25bp to 2.75% and the Philippines’ central bank cut rates by 25bp to 3.50%. The Philippine peso was one of the stronger regional performers however, gaining by more than 1%, as did the South Korean won.
The Australian jobs data was somewhat mixed as September employment rose by 14,500 but the jobless rate climbed to 5.4%. The Reserve Bank of Australia unexpectedly cut its Cash Rate by 25bp to 3.25% in October and the language of the accompanying statement was potentially consistent with further easing. However, dovish expectations were subsequently scaled back somewhat by the Q3 CPI data, which showed headline inflation firming to 2% and core inflation firming to 2.4% y/y. The Reserve Bank of New Zealand left its policy rate unchanged at 2.50% and said rates remained appropriate for now, hinting at steady policy going forward. The Australian dollar saw a modest decline of around 0.5% while the NZ dollar was down by around 1% during the month.
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This month, Risks & Rewards welcomes Derivatives Specialist David Gopal as a guest columnist to discuss “basis” in the foreign exchange and cross-currency swaps market.
Q: I have seen a lot in the news lately on currency basis. What is that exactly and as a corporate hedger, how should I think about basis?
A: Basis is a generic term used in all types of hedging instruments. In the commodity world, basis is used to
Risks & Rewards With Dave Napalo — featuring David Gopal
Derivatives Specialist Wells Fargo Foreign Exchange
the difference in value between different contracts, such as the
difference between the value of a May contract and a June contract for a
specified commodity. In the world of over-the-counter currency
derivatives, it signifies an adjustment to interest rates of one
currency versus another.
Specifically, a basis adjustment is the adjustment to the floating interest rate of one currency versus another. To better explain this, we will provide a quick definition of a cross-currency swap, which contains a basis component.
A cross-currency swap essentially is a pair of loans. Party A may lend dollars to party B, while party B simultaneously lends an equivalent amount of euros to Party A. Each party is both lender and borrower with the other. In theory, the risk-free rate on the dollar loan would be Libor and the risk-free rate on the euro loan would be Euribor, so one might assume the interest rates on the swap are Libor and Euribor. However, that is not the case. There is actually a basis adjustment to reflect true market interest rates. The cross-currency swap would be quoted as Libor flat against Euribor +/- a basis adjustment.
But if Libor represents the theoretical cost of funds in dollars, and Euribor is the theoretical cost of funds in Euro, why is there a need for an additional adjustment? Technically, the answer is that the supply and demand for borrowing is different for different currencies. However, the simple response of supply and demand is hardly a gratifying response.
Digging a bit deeper, it is fair to say that regional bank credit quality and sovereign issues can impact basis. It is often assumed that Libor represents the appropriate unsecured borrowing cost for highly rated US banks. The same can be said of Euribor for European banks. In a normal market, the quality of US and European banks will be similar and any basis adjustment will be small. However, as European sovereign debt concerns have led to fears that European banks will suffer, it has become very difficult for European banks to borrow USD and has increased the cost to those banks to borrow out of country (with a local currency deposit base and government support for such deposits, local currency remained accessible).
Here is a more specific example. European banks were one of the largest users of the US commercial paper (CP) market to fund USD operations and assets. But when the European debt crisis was in full swing, this CP market closed to the European banks. These banks then looked to the swap market where they could borrow USD and lend euro to create the necessary USD funding. But this created significant demand for USD funding and drove up the basis adjustment. In other words, these banks would have to pay Libor plus a spread in return for Euribor. (As mentioned above, the adjustment would actually be a decrease to Euribor as opposed to an increase to Libor).
There is certainly more that can be said about the variety of factors that can drive basis, but ultimately, for a corporate hedger, the concern should be how basis affects a hedge program and whether anything should be done about it.
The direct implication to most FX hedgers is the impact to forward points. A hedger with a “long” Euro position will sell Euro forward, perhaps as part of a rolling balance sheet program. The forward point adjustment to the rate is a function of the interest rates in both currencies as well as basis. The textbook formula for calculating forward points is as follows:
Spot*(1+R¬d)/(1 + Rf) – Spot
Where Rd is the domestic interest rate and Rf is the foreign interest rate, or in the case of a 3 month Euro forward, 3 month US Libor and 3 month Euribor, respectively. In other words the forward points should be a simple function of the difference in interest rates. However the problem with this formula is that it does not play out in practice. In today’s market the forward points imply a much larger interest rate difference than is actually observed from Libor and Euribor. The reason for this seeming inconsistency is, of course, basis. The euro interest rate must be further discounted to reflect the higher cost of Libor for European banks. This yields:
Spot*(1+R¬d)/(1 + (Rf- basis)) – Spot
As a corporate hedger who has to sell euro forward, this basis adjustment has created something of a boon. But the problem is that the basis advantage can shift and even go the other way. For a company that will have to hedge every month until the end of time, a basis shift could be costly. One way to protect against this is to lock the basis adjustment with a cross-currency swap, which can have a life of several years.
Basis can also be a material issue for any funding decisions. Companies that need to borrow any foreign currency should do an analysis of a direct borrowing versus a dollar borrowing paired with a cross-currency swap. The latter will allow a company to pick up any basis adjustment that might present an advantage. On a related note, any company with a multi-currency revolver could look at borrowing in one currency and swapping to another rather than simply borrowing in the currency desired. Who knows, the basis adjustment might just reduce interest expense!
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(either Canadian or U.S. dollars), Mexico, Europe1, Australia, Hong
Kong, India, New Zealand, and Singapore.
How you benefit
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One-bank convenience. Wells Fargo eliminates the need to form foreign banking relationships because we provide complete format conversion as well as foreign exchange and settlement services through your existing Wells Fargo U.S. dollar or multi-currency account. You will not need to factor foreign exchange rates into each transaction prior to transmitting your file. Moreover, you can originate payments in either U.S. dollars or local foreign currency, including euros.
Easy implementation. The international ACH service works the same way as Wells Fargo’s domestic ACH but with a foreign exchange component. You can send domestic and international payments to Wells Fargo in separate batches within one transmission.
Multiple origination options. You have three methods of transferring your global ACH files to Wells Fargo.
Direct origination allows you to create ACH files in-house and deliver them by electronic data transmission.
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Employees or vendors sign authorizations as needed and provide you with their bank account information.
Your company sends the payment information electronically to Wells Fargo using our direct origination, International ACH Payments on the CEO portal, or Payment Manager service.
You can settle global ACH transactions to your U.S. dollar account, and Wells Fargo will either perform the foreign exchange on your behalf at that day’s rate, or use the rate, agreed to in a separate foreign exchange contract entered into in advance with your foreign exchange specialist. You can also settle global ACH transactions to a London DDA (CHF, EUR, GBP, or USD only) or Cayman MCA in the currency you wish your beneficiary to receive.
On the settlement date, Wells Fargo debits your account for the total of all items in the file. On or shortly after the settlement date, we post the individual credit transactions to your beneficiaries’ accounts around the world.
Wells Fargo offers centralized customer service for your global ACH items and work with you to help your company expand its presence in the global marketplace. For more information about our Global ACH service please contact your relationship manager or sales consultant, call International Connections at 1-877-593-2468, or email us at email@example.com.
1Europe includes: Austria France Liechtenstein Portugal Belgium Germany Lithuania Romania Bulgaria Greece Luxembourg Slovak Republic Cyprus Hungary Malta Slovenia Czech Republic Iceland Monaco Spain Denmark Ireland Netherlands Sweden Estonia Italy Norway Switzerland Finland Latvia Poland United Kingdom
International Treasury Management Sales Analyst Atlanta, GA
No, I was born and raised in the city of Vadodara located in Gujarat, India. I can fluently speak and write Hindi and Gujarati.
Did you attend college in India?
Yes, I graduated with BS in Zoology from Maharaja Sayajirao University, Vadodara, India.
When did you move to the U.S. and how did you come to work for Wells Fargo and the International Group?
After graduating from college in 1997, I moved to Atlanta and ultimately joined First Union as an associate in the Wholesale Lockbox Group. I worked in the corporate customer service group during the First Union and Wachovia merger and later moved to the International group in 2010 right after the Wells Fargo merger.
What do you think are some of the factors that lead to a career in International Banking?
To be honest, First Union was the first job that came my way after moving to the U.S. After moving to a new country my first priority was employment. I have really come a long way from when I first joined this bank. I have been able to take that initial opportunity and transform it into a career I enjoy.
What do you like about working with your clients? What do you think are some character traits that have allowed you to become successful?
Building strong personal and professional relationships with my clients is what drives me. I enjoy interacting with them and feel great when I am able to meet their needs. I think being self-confident, determined, and hard working have been a big part of my success.
When you’re not hard at work, are there any hobbies or activities you enjoy?
I really enjoy cooking, playing badminton, and running. I also love spending free time with my husband and two kids. Listening to the so-called “mature conversations” that my 10 and 7 year olds have with each other definitely entertains me.
Featuring: Kajal Mehta People Power had the chance to sit down and talk with Kajal Mehta, International Treasury Management Sales Analyst, in our Atlanta office. We talked about how she moved from India to the U.S. after college, how she has grown her career with the bank over the last 15 years, and some of the activities she enjoys in her free time.
You currently live and work in Atlanta, GA but is this where you are from originally?
A great reason to bank with Wells Fargo