All eyes are on the FOMC meeting this week, but not just for the reasons the media is focused on, like the word, "patient." The Fed Funds rate (which you can trade on Nadex) directly affects loans and consumer spending, but it also affects other markets.
By Vikram Rangala
Monday, March 16, 2015
It is a big factor in how large funds buy stocks or companies do stock buybacks, since they often take on zero-cost debt to finance those purchases. Companies use that zero borrowing cost to finance expansions and new hiring. In a variety of ways, interest rates affect the stock market and most people know that's why stock traders pay such close attention.
The connection to currency exchange rates is less well-known, but it's important because when people buy bonds and stocks, they generally need to use money to do it. And when the sale or purchase is in the billions, it makes a difference which money they use.
CURRENCIES REFLECT PRIORITIES
For example, Berkshire Hathaway is planning to sell $3 billion worth of corporate bonds, the Wall Street Journal reported earlier this month. For the first time, though, the company will be denominating them in euros, because interest rates in the Eurozone are at or below zero. Moreover, investors wanting to buy in euros are looking for alternatives to Eurozone government debt. Euro-denominated corporate debt from some of the world’s biggest companies has been in hot demand as investors, hamstrung by subzero yields on many European government bonds, seek alternative assets to boost returns.
While some firms are looking to euro-denominated debt to fund business activities in Europe, others are in it strictly to exploit the difference between the current monetary policies of the US and Europe. In the US, the Fed is done with its quantitative easing and is planning to raise rates this year. In Europe, the ECB has just started its QE and is keeping rates at or below zero. In a sense, when you're trading something like the EUR/USD, you're trading the contrast between two monetary policies and their effects on the rest of the world.
Bryan Wallace, a fund manager at J.P. Morgan Asset Management, told the Journal:
Even for those companies that have no European operations to finance, selling bonds in Europe is still attractive because the cost of borrowing in euros and swapping the cash back into dollars using a so-called cross-currency swap is around the lowest level on record.
As long as the ECB keeps buying up the debt of Eurozone countries, the cheap euro and cheap borrowing costs will continue. So will the low yields for other buyers.
JAPAN WANTS DOLLARS, NOT EUROS
Not everyone is looking to Europe, however. The Bank of Japan, along with several large Japanese banks and funds, will buy as much as $300 billion in US Treasuries in the next few years, doubling its current rate of purchasing. Japan is already the second-largest holder of US debt, after China.
Why is Japan looking to US government debt? Like Europe, Japan has kept its interest rates near zero since the Bank of Japan began its version of quantitative easing in April 2013 to end its so-called "lost decade" of stagflation following the boom and bubble years of the 80s and 90s. In fact, Japan set the precedent for central bank purchases of government bonds, which the ECB is now following.
US Treasuries, in contrast to those of Europe and Japan, offer the highest yields among debt from the G8 economies. With the Federal Reserve poised to raise rates, they look even more attractive to anyone looking to get a yield rather than prop up a stagnant economy. Japan wants and needs to do both.
And of course, US Treasuries are denominated in US dollars, the currency that has been dominating virtually every other and appears likely to continue doing so for the next year at least. If you bought a US bond for 100 yen and the dollar is now worth 120 yen, you made a great investment. Many yen-based investors, the BOJ included, have made such investments and are eager to make more. So it's not just the interest rate of the bond, but the currency in which the bond is issued that makes a difference to investors.
More than a dozen countries are cutting interest rates or increasing stimulus (buying domestic debt) to grow their economies. The US is doing neither of these things (anymore) and it's already growing. That's the reason the bond market and currency market are connected, even when analysts and investors of one market may say very little about the other.
The US government, for its part, needs continued Japanese demand in the $12.6 trillion market for Treasuries. China made its biggest reduction in US debt holdings last year and as the Fed prepares to raise rates, China's stimulus may require it to purchase more domestic debt rather than US debt.
Luckily for the US, private investors in Japan are having a tough time buying Japanese government bonds even when they want to. The BOJ, which already owns over 20% of JGBs, is on track to buy more of the low-yield national debt. This forces other institutions, like Japan's pension fund, to look elsewhere. They're looking to the US and have already started buying.
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