By Chris Fournier
Feb. 23 (Bloomberg) -- Six months ago, Lee Hardman didn’t care how much it cost to protect government bonds from losses. Now the Bank of Tokyo-Mitsubishi UFJ Ltd. strategist studies derivatives that provide such insurance to predict currency moves -- and he’s betting against the yen and the pound as a result.
“We wouldn’t really have looked at sovereign credit- default swaps in any great detail before” the September bankruptcy of Lehman Brothers Holdings Inc. caused credit markets to freeze, said Hardman, who is based in London. “It’s an area which potentially is going to see increasing focus as a driver of currency rates.”
Traders are starting to use the speculative contracts blamed for fueling Wall Street’s meltdown last year to measure currency strength as countries increase debt sales after pledging at least $2.4 trillion to kick-start their economies. Interest rates are becoming less useful for predicting foreign exchange as central banks slash borrowing costs to zero, narrowing differences between government debt yields.
“The credit-default swap market has taken a lot of bad press,” said Andrea Cicione, a credit strategist in London at BNP Paribas SA, in a Feb. 20 telephone interview. “The traders and the investors who have been involved in the CDS market understand that it’s operating just fine and there’s no need to throw it down a hole.”
Correlated Yen
Originally conceived to protect against corporate defaults, credit-default swaps are now being used to predict the direction of everything from the Canadian to New Zealand dollars. The swaps pay buyers the face value of a bond in exchange for the underlying securities or the cash equivalent if borrowers fail to adhere to debt agreements. Prices of the contracts, increasingly used to speculate on government bonds, rise as the perception of an issuer’s ability to pay decreases.
Since January, the correlation between the yen and the cost of protecting against a default on Japanese government bonds swung to negative 43 percent, showing investor concerns are increasing. The yen and cost of credit-default swaps moved in tandem 88 percent of the time last year.
Government reports show Japan is sinking deeper into recession, with fourth-quarter gross domestic product contracting at an annual rate of 12.7 percent, the most since the 1974 oil shock. The yen slumped 2.9 percent against the dollar this year to 93.35, and is headed for its worst month since April. The yen appreciated 23 percent in 2008.
‘In Play’
The pound traded at a negative correlation of 94 percent in the past year against U.K. debt swaps, showing the currency is weakening as credit perceptions worsen. Sterling dropped 26 percent in that period to 1.4433 per dollar.
Ron Leven, an executive vice president and senior currency strategist at Morgan Stanley in New York, doesn’t buy the argument that swap prices influence currency movements.
“If anything, the currencies are telling you what the swap spreads are going to do,” Leven said in a Feb. 9 interview. Still, every couple of days he updates his charts that show differences in prices of swaps on U.K. and U.S. debt and between New Zealand and U.S. bonds. A year ago he never looked at sovereign swaps.
Eric Lascelles, chief economics strategist at TD Securities Inc. in Toronto, said sovereign swaps don’t trade enough to make a good forecasting tool. Prices are often unavailable in the Canadian swap market, he said in a Feb. 9 interview.
Government bond swaps are “in play and getting the attraction that a moving variable deserves” because the global recession and increasing bond sales boosted the default risks for many countries, Lascelles said.
Regulatory Reform
Credit-default swaps dealers are under pressure from governments and central banks to increase transparency in the unregulated $28 trillion market and to create a body that will arbitrate disputes. The firms agreed to process the derivatives transactions through a clearinghouse following the failure of Lehman, one of the largest dealers.
Derivatives are financial contracts whose value is derived from interest rates, the outcome of specific events or the price of underlying assets such as debt, equities and commodities.
The cost of protecting against default by Lehman, Bear Stearns Cos. and American International Group Inc. rose as high as 7.07 percent before the companies collapsed. Richard Fuld, the former chief executive officer of Lehman, blamed speculation in the market for helping to speed the companies’ demise.
Swap Prices
While swaps don’t suggest Japan is close to default, the cost of protecting Japanese government bonds more than doubled to 1.21 percent of the face value on Feb. 17, from 0.49 percent on Jan. 30, according to CMA Datavision. A basis point, or 0.01 percentage point, on a credit-default swap contract protecting $10 million of debt for five years is equivalent to $1,000 a year, or $121,000 for the Japanese bond.
The U.K.’s swap price increased to 1.75 percent, or $175,000, on Feb. 17, from 1.23 percent. The pound declined 0.8 percent since Jan. 30.
Before Lehman’s failure, neither country’s swap price exceeded 0.74 percent. Hardman said the ballooning costs signal further depreciation. He expects the pound to drop to 1.35 per dollar by the end of the first quarter and yen to weaken to 100 per dollar by the end of 2009.
Japan’s Prime Minister Taro Aso announced plans in December to inject as much as 12 trillion yen ($127.6 billion) into the nation’s banks. The government cut its assessment of the economy for a fifth month last week, fanning speculation more fiscal stimulus will be needed.
‘Falling Apart’
“Should these conditions continue, we could say that the Japanese economy is at risk of falling apart,” Finance Minister Kaoru Yosano said in the Diet in Tokyo on Feb. 18.
The British currency fell to a two-week low that day after the Daily Telegraph said the country’s credit rating may be lowered by Standard & Poor’s as the government increases borrowing to bail out banks. U.K. policy makers voted 8-1 on Feb. 5 to cut the main interest rate by half a percentage point to 1 percent.
President Barack Obama enacted a $787 billion economic- stimulus package last week. China is rolling out 4 trillion yuan ($586 billion) to prop up domestic demand. European leaders pledged to spend a combined 200 billion euros ($257 billion) to haul their economies out of recession.
Traders are looking at credit-default swaps in part because interest rates are losing their effectiveness as a tool for predicting currencies’ direction after central banks in 11 of the world’s largest economies lowered borrowing costs an average 2.2 percentage points last year, according to data compiled by Bloomberg. Rates are below 1 percent in the U.S., Japan and Switzerland.
‘Nothing to Distinguish’
“You have nothing to distinguish any more in terms of monetary policy,” said Michael Hart, a London-based analyst at Citigroup Inc. “Several countries are at or near zero, so interest rates are reflecting credit concerns much more than anything else.”
The market for sovereign contracts had 132,200 outstanding contracts with an underlying value of $1.69 trillion as of Feb. 13, representing about 5.9 percent of the total market for credit default swaps, according to the Depository Trust and Clearing Corp.’s Web site. Swaps on financial institutions are the largest segment, with a notional value of $3.2 trillion.
Swap prices have increased the most for the U.K., Sweden and Australia since Lehman’s collapse, according to Hart. Currencies of those countries were three of four worst performers since August, when measured in trade-weighted terms, Hart said in a Feb. 2 report. The New Zealand dollar was the other.
“Default swaps will become increasingly important, given the issuance tsunami awaiting us,” Hart said in an interview. “The credit-default market is a better indicator of fiscal concerns with respect to each country.”
To contact the reporter on this story: Chris Fournier in Montreal at cfournier3@bloomberg.net
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