Super Fund in Australia

Australian superannuation funds that failed to hedge their forex exposure took a hit when the Australian dollar fell against its US counterpart in 2011. Is there a solution in the cross-currency basis swap market?

As Australia increases its ownership of offshore assets across global equities, real estate, infrastructure and other alternative asset classes, foreign exchange has become a major contributor to the investment returns of Australian pension funds.

According to the 2011 Superannuation FX Survey by National Australia Bank (NAB), which polled 49 of the country’s largest super funds with combined AUM of A$523 billion (US$560 billion) representing 79% of the market, unhedged portfolios lost 12.7% in 2010 on adverse currency moves alone, while 100% hedged positions gained 4.5%.

Since mid-2009 the effect is more pronounced, with unhedged positions giving up 30% against gains of 8% for fully hedged positions. The 38% differential represents an opportunity cost to overall portfolio performance of some 3.25% per annum since then, according to NAB.

Against a backdrop of increasing offshore exposure and a focus on relative performance versus their domestic peer group, it should follow that Australian super funds have significant interest in optimising their currency overlay strategies. Outside of the fixed interest sector, however, investment managers say there is little consensus around forex risk management best practice with some funds ignoring it altogether.

Troy Rieck, managing director with the Brisbane-based Queensland Investment Corporation (QIC), an institutional investment manager with AUM of A$60 billion, reports a disparate range of operational approaches. “Some funds use their asset managers to run forex hedging strategies, some rely on their custodians, while others choose not to hedge or don’t really think about it at all,” he says.

Furthermore, the tendency of incumbent providers to rely on traditional hedging tools can act as a drain on liquidity with painful consequences. Between July and October 2008, the Australian dollar dropped by more than 30% versus the US dollar, leaving funds long the Aussie dollar after one-month and three-month AUD/USD forex forward hedges faced a severe, one-off liquidity event. As the deeply out-of-the-money contracts expired, funds faced payouts that far exceeded their strategic cash holdings. Assuming a 30% decline in the AUD versus the US dollar, and net unhedged forex exposure of 17%, the average fund was forced to pay as much as 5.1% (30% x 17%) of its total fund value.

With this experience still fresh in their minds, investment managers are getting excited about a forex overlay approach that has been a favoured tool of international bond issuers and fixed income portfolio managers for some time. The strategy employs longer-dated cross-currency basis swap contracts – plain vanilla derivatives contracts quoted on multiple screens, which advocates argue allow funds to better manage liquidity requirements by smoothing out income gains and losses. Moreover, they argue, it is accretive to the overall risk-adjusted portfolio returns.

“The rollover risk arising from FX overlay programmes based on short-dated contracts can be very large, as the past few years have shown. By using longer-dated cross-currency basis swap contracts, funds can improve the liquidity profile of their FX overlay, and get paid for a risk management activity which they have to do anyway,” says QIC’s Reick.

Funding requirements

The opportunity for better risk-adjusted forex overlay performances is driven by market expectations around the offshore funding requirements of Australian financial institutions. Essentially, the more offshore debt issuance announced by Australian banks, the greater the cost of converting that funding back to the domestic currency using cross-currency basis swaps and vice versa.

At the same time, the relative issuance activities of international borrowers in the kangaroo (domestic Australian) market can have an offsetting effect, with increased issuance and related supply of the domestic currency acting as a cap on basis swap spreads. Since the global financial crisis, broad capital market liquidity and the general availability of funding has amplified the supply/demand dynamic, with the AUD/USD bases turning deeply negative during the Lehman crisis in late 2008 and widening substantially in 2010 on the back of heavy offshore issuance.

Australian banks have recently increased US dollar and euro covered bond issuance as demand for senior bank paper dried up. Issuance of US dollar-denominated asset-backed securities by Australian banks, for example, grew to more than US$1.8 billion in 2011, up from around US$750 million in 2010, while US dollar covered bond issuance grew to US$2.2 billion in 2011 from zero in 2010. Growth of euro covered bond issuance is even more pronounced, with US$17.6 billion-equivalent printed across 18 deals in the first quarter of 2012 alone, according to data provided by Dealogic.

Although the AUD/USD cross-currency basis has tightened in from the 2010 levels across its term structure, increased offshore issuance has kept the basis at elevated levels so far this year.

AUD

The G20 meeting in Mexico did little to quell global markets overnight as very little was achieved leading the slide of risk assets through the early part of trade.  The Finance ministers failed to agree on any increase to the IMF contribution to the Euro zone debt fund.   Although Germany did bear some of the blame for the lack of agreement they did manage to convincingly pass the second EU/IMF bailout of Greece by 496 to 90 votes.  This however did not spur confidence with European stocks dragged down, and demand for the US dollar increased with the Australian dollar trading back to 1.065 and the Euro slipping down to 1.3366 at the start of the US session. 
 
With confidence low a surprise print on pending how sales turned the US session on its head.  The S&P was down over 100 points at the start of the US session, but rebounded as monthly pending homes sales came in at 2% nearly double what was expected.   The S&P finished up 0.14%, and as a result the US dollar was sold off with the Australian dollar following equities as it peaked at 1.07820 USD a few hours ago.   There weren’t any other key economic news out overnight which extenuated the bounce from the G20 through to the pending home sales. 

After a solid run for the month of February the Yen depreciation march halted overnight as it retreated from it 8 month highs.  The price of oil is getting the blame for this demand for the Yen as WTI futures price of 107.81 worrying the ability for the US economic recovery and seeing bullish bets on its recovery possibly being unwound.   We do have Japanese retail sales data out from January this morning with a 0.2% contraction expected. 

Today’s local session does not have any economic data of note and the US equity session saw profit taking occur as it wound up which has given the local session little to open on.  The Australian dollar is 25 pips off its the high following the late paring of gains and we don’t expect too much volatility unless Japanese retail sales data is well away from median estimations.  At the time of writing the Australian dollar is buying 1.0749 USD.

AUD

Forexpros - The Australian dollar ended the week lower against its U.S. counterpart on Friday, as markets were jittery amid ongoing concerns over Greece’s debt woes despite signs of progress in the euro zone.

AUD/USD hit 1.0596 on Thursday, the pair’s lowest since February 1; the pair subsequently consolidated at 1.0693 by close of trade on Friday, shedding 0.71% over the week.

The pair is likely to find support at 1.0591, the low of January 27 and resistance at 1.0773, the high of February 16.

Sentiment slightly improved earlier in the week after euro zone finance ministers agreed to deliver a EUR130 billion bailout package to Greece. 
However, Eurogroup Chairman Jean-Claude Juncker said on Friday that he could not rule out that Athens may need a third bailout.

Meanwhile, Reserve Bank of Australia Governor Glenn Stevens said Australia’s benchmark interest rate is “about right for the moment” as economic growth is close to trend while concerns over the effects of the euro zone’s debt crisis on global output eased.

The Aussie remained supported after Greece launched a bond-swap offer to private-sector creditors, formally inviting them to exchange their holdings of government debt for new securities. 

Meanwhile, markets were eyeing the European Central Bank, scheduled to launch a second liquidity operation next week, offering unlimited three-year loans to European lenders, after the bank carried out a similar successful operation in December.

In the U.S., a string of improved economic data lifted sentiment. A report by the University of Michigan on Friday showed that its index consumer sentiment rose to 75.3 this month from 75 in January.

On Thursday, the U.S. Department of Labor said that the number of individuals filing for initial jobless benefits in the week ending February 18 held steady at 351,000, the fewest since March 2008.

Earlier in the week, the Reserve Bank of Australia said in the minutes of its February meeting that it remained willing to ease policy if commodity and raw material demand were to “weaken materially” although it left rates unchanged this month. 

Meanwhile, official data showed that Australian wage prices rose more-than-expected in the fourth quarter, adding 1% after a 0.7% increase the previous quarter. Analysts had expected wage prices to rise 0.8% in the fourth quarter. 

In a separate report, the Melbourne Institute said that its inflation gauge for Australia rose 0.5% in January after a 0.1% fall the previous month.

The data came after a report by the Conference Board showing that its leading index for Australia rose 0.2% in December after a 0.3% decline the previous month.

In the coming week, markets will be watching developments in the euro zone, with investors eyeing the uptake on Wednesday’s refinancing operation by the ECB, as well as the outcome of votes in Finland and Germany on Greece’s bailout.

Investors will also be focusing on Wednesday’s U.S. data on fourth quarter economic growth, in order to gauge the strength of the country’s economic recovery.

Ahead of the coming week, Forexpros has compiled a list of these and other significant events likely to affect the markets. The guide skips Friday as there are no relevant events on this day.

USDAUD

The Dow Jones-FXCM U.S. Dollar Index remains 0.34 percent lower from the open after moving 109 percent of its average true range, and the greenback should continue to track higher over the next 24-hours of trading as the 30-minute relative strength index bounces back from oversold territory. Looking at the broader channel, the dollar looks poised for another move towards 9,900, and we maintain a bullish outlook for the reserve currency as the fundamental outlook for the world’s largest economy continues to improve. However, as risk trends continues to dictate price action across the financial market, the rise in market sentiment may keep the USD within a narrow range, and we may see the dollar consolidate further before making a larger move to the upside.

As the more robust recovery in the world’s largest economy curbs speculation for another large-scale asset purchase program, the bullish sentiment underlining the USD should continue to gather pace over the near-term as Fed officials soften their dovish tone for monetary policy. Indeed, central bank hawk Richard Fisher talked down speculation for more easing, arguing that the FOMC’s most recent policy statement was ‘talking down the economy,’ and went onto say that expectations for another round of quantitative easing is ‘wishful thinking’ as the recovery gathers pace. The less dovish stance held by the central bank should prop up the USD going forward, and the index looks poised to work its way back towards the 61.8 percent Fibonacci retracement around 9,949 as index finds intraday support around the 50.0 percent Fib around 9,830.

All four components advanced against the greenback, led by a 0.49 percent rally in the Australian dollar, but the technical outlook for the high-yielding currency instills a bearish forecast for the AUD/USD as the pair breaks out of the upward trending channel from earlier this year. As the AUD/USD struggles to hold above 1.0700, a close below the 20-Day SMA (1.0705) could pave the way for a move lower, and we may see the exchange rate fall back towards the 23.6 percent Fib from the 2010 low to the 2011 high around 1.0350-60 as it appears to carving out a top around 1.0800. However, as the aussie-dollar maintains the range from earlier this month, the exchange rate may continue to move sideways before we see a meaningful break in the exchange rate, and the pair may preserve the 200pip range going into the following week as market participation tends to thin ahead of the weekend.

AUD

Has the Australian dollar called time on European equities’ rally?

Perhaps. The AUD/USD pair has had a long positive correlation with Euro Stoxx futures, going back more than six months. This seems reasonable enough as both fit neatly into the “risk asset” category of markets that are likely to rise when investors feel a bit happier about the economic future.

Moreover, as perhaps the “risk on” asset par excellence, the Aussie is more closely correlated with European stocks than other markets you might think were more natural Euro Stoxx bedfellows, such as EUR/USD or German bund yields.

However, according to Paul Day, chief strategist at Market Securities in London, in the past couple of weeks there have been signs of divergence. Euro Stoxx futures have edged upward even as AUD/USD has made technical analysts nervous with the ominous pattern of “lower highs and lower lows” that usually marks a change in bull-market fortunes.

And there are others who think the Aussie is looking dizzy at its current altitude.

Morgan Stanley points to weakness in the Chinese export order index.

“This provides further evidence that demand in developed markets remains weak, which should not bode well for the high-beta commodity currencies,” the bank’s foreign exchange strategists wrote.

However, they don’t expect an AUD collapse, or anything like one; rather a correction of recent gains. The bank is looking for a return to the $1.05 to $1.0450 area in the near term. The pair was at $1.0633 at 0645 ET Wednesday.

If they are right, correlations suggest that the road for European stocks may get rougher, but it should at least remain passable.

AUD/NZD

A morning foreign exchange rate note from Barclays Capital has noted that the investment banks fair value model suggests the downside risk to the AUD/NZD is likely to be limited and the bank therefore maintain their medium-term forecast of 1.26.

Relative Australia and New Zealand data and likely interest rate trajectories point to further downside in Australian dollar / New Zealand Dollar from current levels.

New Zealand data have, on average, beaten expectations more often than Australian data in recent months, pointing to the risk of a fall in AUD/NZD to around 1.25 by end-March. 

USD/AUD

The Dow Jones-FXCM U.S. Dollar Index remains 0.21 percent higher from the open after moving 79 percent of its average true range, and we may see the greenback track sideways over near-term as it breaks out of the upward trending channel from earlier this month. As the 30-minute relative strength index falls back from a high of 66, we should see the USD hold within the Bollinger Bands going into the middle of the week, but the fundamental developments coming out of the world’s largest economy may prop up the reserve currency as the more robust recovery dampens the scope for another round of quantitative easing.

As the USDOLLAR struggles to hold above the 50.0 percent Fibonacci retracement around 9,830, the failed run at the 50-Day SMA (9,888) could produce a short-term correction in the index, and we may see the index fall back towards the 38.2 percent Fib around 9,710 as market sentiment picks up. However, as the economic docket is expected to show a more robust recovery in the U.S., we may see the greenback may extend the rebound from 9,672, and the reserve currency may continue to recoup the losses from earlier this year as the Fed has limited scope to push through another large-scale asset purchase program. In turn, the dollar index could be putting in a higher low around 9,800, and we will be looking for additional USD strength as the central bank softens its dovish tone for monetary policy.

Three of the four components weakened against the greenback, led by a 0.62 percent decline in the Australian dollar, but we may see the high-yielding currency trend higher over the next 24-hours of trading as market sentiment improves. Indeed, it looks as though currency traders are betting on a short-term reversal as the AUD/USD threatens the upward trending channel carried over from the previous year, and the pair looks to be carving out a major top in February as there appears to be a bearish divergence in the relative strength index. However, we anticipate to see higher prices should the pair continue to close above the 20-Day SMA at 1.0702, and the aussie-dollar may consolidate before we finally get a short-term correction in the exchange rate.