Monday, May 14, 2007

FX Carry: A SAFE haven

Financial markets are getting almost as China-obsessed as Macro Man (and Brad Setser.) Macro Man's email box is chock full of acronym-stuffed research reports, as economists and strategists debate the impact of QDII (which now allows retail investors to buy paltry amounts of foreign equities), PIC/SIC/JFEC (the yet-unamed sovererign wealth fund, which presumably will buy more serious amounts of foreign equity), and the CAS (the ginormous current account surplus in China) ahead of next week's SED (the strategic economic dialogue between the US and China.)

Whew. It's almost enough to make one wish to forget finance and take up poetry. In his periodic discourse on the FX carry trade, Macro Man has occasionally referred to SAFE as the world's biggest carry trader, given the size of their reserves and their evident aversion to low yielding currencies like the yen and swissie. Given the current focus on the RMB (which has just started to appreciate a bit more quickly against the $), Chinese equities, PBOC reserve growth, and the forthcoming sovereign wealth fund, Macro Man thought it would be an interesting exercise to figure out how SAFE's FX reserves have actually performed for them.

The rules of engagement naturally entailed some simplification and guesstimating. Macro Man assumed that SAFE holds a constant reserve basket of 70% USD, 25% EUR, and 5% GBP, and that these reserves are kept in 2 year government securities. He then assumed that all FX intervention is sterilized (which we know it is not) through the issuance of 2 year bills (another simplification.) Essentially, what we are trying to calculate is how the return on a stylized reserve basket compares with PBOC liabilities and/or domestic alternatives- short dated RMB paper. The calculation starts on the day after the RMB reval in July 2005.

Macro Man wasn't really sure what to expect from the calculation. The RMB has outperformed the onshore forwards against the dollar, but it has fallen against the euro and sterling. In any event, he knew that carry would be a substantial positive contributor to overall returns.

In point of fact, carry is the only thing that has kept reserve returns positive. In nominal terms, the RMB has appreciated 2% against the USD/EUR/GBP basket since July 22, 2005. However, the average yield on 2 year RMB paper has been 2.25% lower than that of the weighted reserve basket over the period of the study. This has taken the cumulative return from -2% to +2% over the period of the study. So it's true, then: SAFE is the world's biggest carry trader!
The numbers may also explain why China has, to date, demonstrated an aversion to the yen. Switching even 10% of the dollar exposure into yen would have a substantially negative impact upon returns, both nominal and carry adjusted. The yen's weakness against the dollar would take the nominal return from -2% to -2.85%, while the reduced carry of the reserve basket would bring the all-in return from +2% to less than +0.50%. And that, you'll agree, is uncomfortably close to a money-losing proposition.

What is particularly interesting is the trajectory of the returns. SAFE made plenty of money in the first year after the revaluation, but hasn't made a dime since. In actual RMB terms, the returns from the FX reserve holdings has actually been negative since June 2006. This, perhaps, is the real motivation behind the sovereign wealth fund. The powers that be may have recognized that returns from the business-as-usual reserve basket have dwindled to zero even as reserve growth has turned parabolic. It's difficult to justify adding so many reserves when you're not getting an economic return for it. So perhaps the PIC/SIC/JFEC has been created to ensure that the return curve swings back onto a positive trajectory. Regardless, it's hard to escape the conclusion that FX carry has been a haven for SAFE.

A couple of portfolio clean up notes. Commodities are killing Macro Man. If the Goldcorp position were any more of a dog, he'd have to put a flea collar on it. Meanwhile, the crude spread trade has run him over like a cartoon steamroller. The time has come for remedial action. Macro Man will sell out the Goldcorp on today's open and bid it good riddance. The oil spread requires a bit more delicacy. The first order of business is to trim the COZ7 short- Macro Man will bid 69.50 to cover that. Once done, he will offer the CLZ7 at 68.50. Market noise will hopefully provide him with an opportunity to leg out of the position at a one buck discount, though sod's law says the Brent leg will get filled just before the discovery of Osama bin Laden in Afghanistan and a massive deposit of crude in Nebraska.

Categories: ,


Anonymous said...

Perhaps this is just splitting hairs but one could argue that the Japanese Ministry of Finance is really the world's best carry trader for a number of reasons: 1) they've been at it for longer and have thus accrued more profit, 2) carry is larger meaning they hoover up more pennies every month, 3) they have historically been more active at buying the lows in USDJPY (note acceleration in reserve growth, bbg ticker JNFRRSRV Index, in the 1994-1995, 1999-2000, and 2002-2003).

Macro Man said...

Oh yes, I completely agree. The P/L that the MOF has made from its 1Q04 intervention alone is probably $70 billion or so.

Of course, that's nothing co mpared to their purchases of USD/JPY in the 80's (that's price, not time) and subsequent sale in the 130's and 140's 3 years later. Genius!

SAFE, however, seems quite clearly the biggest, given the size of their portfolio.

"Cassandra" said...

The BoJ is not bad at trading stocks either:

See BoJ's Hot Hand

RE: The MoF/BoJ - It's easy to buy the dips in spades if you know i.e. possess the material non-public information that ZIRP or nearZIRP is/will continue to be the prevailing policy until ummmm errrr USA governemnt/people alter their respective fiscal/monetary savings/consumption policy mixes (i.e. when Italians go en-masse to Germany for culinary vacations).

Quarrel said...

Really interesting insight.

From a traders perspective you can see them wanting to manage the incremental returns as well as they can, and if the carry trade works (and works without having to get too much out of USD which might be a problem) then great.

However, Brad Setser's thoughts (and some of your own musings on Voldemort) on this accumulation worry me on a "more" macro level .. What's the end game for SAFE here? They're accumulating at stupendous rates and intervening in the FX market at greater and greater rates.

What choice do they have? And how does it end profitably for them, and without screwing the market in the process? How should they be managing it better? Floating the RMB may help, but they seem to be trying to establish a banking system to cope as fast as they can..

While I understand yours was more a study on the carry trade in general, I think if SAFE thinks in terms of their month-to-month returns they'll hit a wall not faced by mere mortal traders.


James said...

The record amounts intervention in the capital markets certainly make free trade much less real than is actually reported. Asia and the reserve accumulaters are flat out running the show. The private sector is being forced to do PE because they can't find any alpha.

Quarrel said...

All good trades come to an end eventually. I'm not sure I buy the concept of alpha disappearing because of cb intervention. Alpha just goes somewhere else.

So maybe we explore for a while, but the cb's ultimately have different agendas, and aren't necessarily chasing profit (at least in the same terms or on the same time frames).

Anyway, throw in a US hard landing and I'm sure something will come up :)


Macro Man said...

While the Japanese authorities have no doubt made some decent scratch from trading domestic equities, I suspect that the HKMA takes the cake for best stock return, given what the Hang Seng has done since their buying spree ten years ago during the Asian crisis.

What's the endgame for PBOC/SAFE? If and when domestic interest rates rise sufficiently high that FX intervention starts costing money, one would presume that they will have to intervene less. One suspects that the reason for the QDII shift and for PIC/SIC/JFEC is to find an alternative seller of RMB.

With regards to the latter, I am not in any way suggesting that SAFE feels constrained by daily or monthly P/L shifts. However, it does seem clear that it is becoming ever more difficult politically to keep RMB appreciation slow enough to ensure a profitable return on SAFE's portfolio- hence the shift into riskier assets.

As to where the 'alpha goes'...well, one could argue that the lack of exchange rate volatility is a real boon to corporations, and makes them more profitable by reducing hedging costs. So perhaps the missing FX alpha is now part of the irrepressible equity beta!