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The Taiwanese greenback recovered its footing at present, however as we’ve written before, what occurs in Taiwan may not keep in Taiwan.
Understandably, there are nonetheless issues that the latest sprint for greenback hedges from Taiwanese life insurance coverage corporations is just too late. JPMorgan analysts yesterday warned that Taiwan’s lifers will “be the foremost victims of TWD appreciation”.
Nonetheless, as Joshua Youthful and Brad Setser wrote in Alphaville earlier this yr, there was a “bizarre monetary dance between Taiwanese life insurers and US homebuyers”, due to the growth in so-called Formosa bonds.
These are bonds issued in Taiwan by overseas corporations, and denominated in {dollars}. About half of the roughly $300bn value of Formosa bonds are callable, based on Barclays. In observe, as Youthful and Setser explained, they perform as promoting US rates of interest volatility and within the course of in all probability helped dampen US mortgage prices.
Formosa bond issuance has slowed down so much for the reason that Fed began jacking up rates of interest in 2022, however given the big inventory of debt already issued, may the latest turbulence have an effect within the US?
Most likely not, Barclays analysts argue:
The transmission mechanism that USD charge vol market traders are involved about includes one wherein Taiwanese insurers unwind their callable publicity, inflicting a scramble for vega shopping for. Such a sequence of occasions strikes us as extraordinarily unlikely. There are lots of potential responses to the foreign money transfer and it appears to us that promoting unique devices similar to long-dated callables is prone to be a lot additional down the listing.
Because the quick danger is from the foreign money, the primary order response is to hedge the foreign money danger. Which will create additional strain for appreciation, however there are methods for the central financial institution to handle that, and it doesn’t instantly translate into both length or vol influence in USD charges.
However most vital, whereas long-dated callables account for a considerable amount of vega provide to the US vol market, the FX danger that they pose is probably going fairly small even relative to the opposite overseas foreign money holdings of Taiwanese lifers.
Worth motion in US rates of interest derivatives additionally doesn’t point out any mass unwind by Taiwanese lifers both. Nonetheless, Barclays’ analysts reckon that there may nonetheless be a longer-term impact on the US bond market from the collapsing chance of the Formosa bond phenomenon flowering once more.
That alone may ripple by way of the US charges complicated. As markets value within the fading probability of a Formosa bond renaissance, it means rates of interest volatility must be priced greater, and — all issues being equal — add somewhat to US mortgage prices.
Or, in sellsidespeak:
One danger that lengthy vol traders fear about is the danger of a sudden surge in vol provide from a re-emergence of callable issuance, which then causes long-dated volatility to fall. This might conceivably occur in an setting wherein charges are so much decrease than present ranges (say due to a significant recession). We now have thought of this danger to lengthy vega traders to be comparatively low, on condition that any giant sufficient charge transfer to trigger this to occur would, not less than initially, be vol-positive.
However the present episode could trigger Taiwanese lifers to hesitate in investing in less-liquid devices similar to long-dated callables even after they do spend money on USD property sooner or later, particularly now that we’re shifting to an setting the place US tariffs will imply much less demand for greenback devices from overseas traders. So, for vol market individuals, the danger of sudden drops in long-dated volatility from provide shocks must be decrease shifting ahead.
As a second order impact, one purpose why the skew in volatility in lengthy expiries is so excessive (low strike volatility decrease than excessive strike volatility) is as a result of the market expects vol provide to come back again in low charge eventualities. With this chance falling, there may be a repricing of the long-dated skew to be extra symmetric.
