Since the Global Financial Crisis in 2008, institutional investors have been operating in a ‘lower-for-longer’ rates environment that has been awash with the liquidity created by massive quantitative easing (QE) stimulus programmes.
This benefited investors in Asia Pacific (APAC) as they relied on a bond market that rose consistently, and an equity market which, despite some short-term disruptions, also showed positive growth over the longer term.
However, profound disruptions to global prices resulting from the pandemic and ongoing conflict in Ukraine have forced the US Federal Reserve and other policymakers to change their approach.
The Fed’s policy is pivoting away from QE, and other central banks are following suit; in an effort to cap rising inflation, they are rapidly raising rates. The Fed is shrinking its balance sheet every month, reducing some of the rampant liquidity in the markets.
The result is an end to the multi-decade bull market for bonds and intense volatility across all asset classes. It is a shift that has implications for investors everywhere, not least in the APAC region.
Traditional 60/40 portfolio theory no longer works. Looking ahead over the next three years, this dynamic will drive huge shifts in portfolios and strategies as institutional investors seek new sources of growth and ways to manage fresh downside risks.
Dollars in demand
So how are the world’s biggest investors thinking about the future? What do higher US interest rates mean for Asia?
The most obvious result of the Fed’s rate hikes is a surge in global demand for US dollar assets. Driven by higher yields on US bonds and safe-haven buying, the US dollar has been on a tear against other major currencies in recent months. The euro slid below parity in August, and the US dollar index set a fresh 20-year high in late September.
This surge in dollar demand is expected to be long lasting, especially as international appetite for US dollar assets has been strong in recent years. This increased global flow of US dollars is now a fixture of the world’s money markets.
According to the Congressional Research Service (CRS), foreign holdings of US Treasury debt increased by US$1.5 trillion to US$7.7 trillion in the four years to December 2021. Overseas governments and central banks held 53.7% of this total at the end of 2021, with private investors accounting for 46.3% (US$3.6 trillion).
On top of this, international institutions and corporations have accumulated other dollar-denominated assets, including stocks, bonds and derivatives such as swaps, futures and options.
When this is institutions’ basic position and they are not located in a US dollar jurisdiction, they need to borrow dollars every day to run these long dollar-denominated positions. Many of these institutions run balance sheets that are leveraged 20 to 30 times, which equates to a large sum of US dollar assets that need funding on a daily basis.
Banks play a critical role in supporting institutional investors’ funding needs. BNP Paribas, named Derivatives House of the Year in Europe and Asia in the 2022 Global Capital Derivatives Awards, is at the centre of these global fund flows, offering a full array of products to support the dollar servicing business.
As dollars become more expensive, investors need more sophisticated risk-management programmes and cash alternatives.
Brian McCappin, Deputy Head of Global Markets for APAC and Head of Global Markets (GM) Institutional Sales for APAC, BNP Paribas
As dollars become more expensive, investors need more sophisticated risk-management programmes and cash alternatives. This appetite for dollars is likely to be a long-term factor in the markets – requiring the financial institutions that service these clients’ funding requirements to redouble their efforts.
China looks offshore
The fundamental change in US rate policy has particular implications for China, the world’s second-biggest economy.
At the start of 2022, the yield on a 10-year Chinese government bond was more than 100 basis points higher than the US 10-year Treasury benchmark. That yield advantage has since reversed dramatically: at the end of September, the US 10-year paid more than 100 basis points over the Chinese equivalent.
Unlike most central banks, the People’s Bank of China (PBOC) is cutting rates and is likely to maintain a downward bias for the foreseeable future. Lower rates mean a flat yield curve for domestic fixed-income instruments, so they are less attractive investments.
While the US and Europe have become used to dealing with a low-rate scenario for years, it is new to China. The PBOC Lending Rate averaged 6.55% between 1991 and 2021, but was cut to 3.65% in August. At the same time, most global rates are moving sharply higher, making overseas investments more attractive.
This means China’s large domestic banks, such as ICBC, China Construction Bank and Bank of China, are beginning to scale up their international operations, embarking on a path previously travelled by Japan’s local banks in the 1990s.
This is a tremendous catalyst for the outward deployment of Chinese capital. The business China’s banks conduct in London and New York will pivot significantly from servicing domestic balance sheets to a new focus on global balance sheets – supporting the internationalisation of China’s manufacturers and technology companies.
A strong example of this is Geely Auto, China’s fifth-largest motor manufacturer, which acquired Volvo in 2010 and Lotus in 2017.
Geely now has five R&D centres globally: in addition to those at home in Hangzhou and Ningbo, it is now established in Gothenburg, Coventry and Frankfurt. Banks need to be able to provide short and long-term financing for such increasingly multinational operations.
Creating the corridor
Financial institutions need to react quickly to keep pace with these fundamental changes in global investment flows.
BNP Paribas has been redesigning key products and services to offer effective hedging, algorithmic and electronic trading, and access to innovative ideas and insights to Chinese clients who are now looking overseas. With the Bank’s long history and strong local presence in APAC, it is ready to partner with regional investors and corporates as they respond to changing geopolitical and macroeconomic conditions.
We want to be able to advise our Chinese clients as part of their investment process, both as they manage their US dollar requirements, and move their investment focus significantly offshore. This is what a service-oriented business should do to facilitate its clients’ global ambitions. And this is how we ensure that our own business grows alongside theirs.
Brian McCappin, Deputy Head of Global Markets for APAC and Head of Global Markets (GM) Institutional Sales for APAC, BNP Paribas