Following Chairman of the US central bank Ben Bernanke’s comments last Wednesday that the Fed would be reviewing the ongoing Quantitative Easing (QE) programme, with the view of easing the US$85b per month bond buying programme designed to stimulate growth later this year (with the programme removed in 2014 depending on economic data), global markets sold off dramatically as investors switched out of equities, government bonds and ‘risk assets’ including the AUD.
The sell off reflects the market’s re-assessment of the view of ‘free money forever’, where taking risk (buying risky assets like equities) was essentially underwritten by the Fed’s continued stimulus of the economy. Without the stimulus (as was foreshadowed in the Fed’s comments), investors began to actually look at risk, and the price they were paying, and didn’t like what they saw. Prices (and risk) were essentially being underwritten by the external stimulus provided by the Fed, not by fundamental economic growth.
So after diving into equities over the last six months, investors stampeded back out, wiping off most of the market gains made this calendar year. Large movements were also seen in currency and bond markets, the latter impacted by the realisation that a very larger buyer of bonds will no longer be there when QE is removed and hence reducing buying demand. The market reaction was a fall in government bond prices and an increase in yields (given the inverse relationship between fixed rate government bonds and yields). This in turn impacted swap markets.
The graph below shows the movement in the 5 year AUD swap curve over the last two weeks. It is not hard to guess which day Ben Bernanke made his comments.
The 5 year swap curve (effectively the rate the banks will lend amongst themselves) jumped from 3.3550% on the 19th of June, to 3.8275% today – a move of 47.25bps. Whilst this (the 5 year curve) represents a specific point, this widening was repeated throughout the swap and government curves resulting in a dramatic steepening.
Short cash/Long bonds
If we look at the change in the 5 year swap curve from 12 months ago to today, we can see the dramatic effects of recent market movements, and this presents a trading idea for investors.
In the graph below we can see the pale blue line showing what the swap curve looked like 12 months ago (on 25 June 2012). It is roughly a shallow ‘U’ shape. What this shows is that 12 months ago there was tremendous value on offer in the short dated market, which for most investors is the term deposit market. In fact, the curve was offering better returns for 30 days than it was for 3 years. At this point it made sense to invest in term deposits, with their government guarantee, and take the strong rates on offer.
Fast forward 12 months, and the curve has changed dramatically. No longer a ‘U’ shape, the curve (the dark blue line), has moved into a more traditional upward slope. This upward slope has been further exaggerated by the moves over the last two weeks on the back of the comments coming out of the Fed. As you can see, the short dated (term deposit) money is no longer offering the great returns which were around last year, however the dramatic steepening of the curve from one year out is offering returns for investors prepared to invest in longer maturities.
The dramatic change is best displayed in the graph below, which plots the change in the yield curve from 25 June 2012 to 25 June 2013.
Short of the two year point, we have seen a dramatic drop in the curve. I am probably not telling anyone anything new in that this has dramatically cut the 30, 60, 90 day, 6 and 12 month term deposit offers available. Beyond the two year mark, we can see rates have increase from 12 months ago – offering investors much better returns to take the longer maturity than 12 months ago.
So what is this telling investors? There is no longer the value in term deposits which was present 12 months ago and the value has returned for those investing with longer maturity horizons.
For those still sitting on cash, it is an opportune moment to rebalance their portfolio, taking on some longer dated exposures. The best value we currently see are bonds maturing around the five year mark, maturities in the 2018 - 2020 range.
Widening in spreads
In addition to the steepening in the yield curve, we have also witnessed a widening of credit spreads (via the Itraxx index) over the last two weeks. Again, this is in part reflecting market reactions to Ben Bernanke’s comments and has seen the Itraxx index (a measure of credit risk, or spread) move out from 119bps to 149bps over that period.
This reflects the market’s re-assessment of risk under the removal ‘free money forever’ scenario under which the market has been operating in recent times. Once again this has coincided with Bernanke’s comments on the likely cutting of QE and the dramatic drop in equities over the same period. There is also the likelihood that there is some ‘desk clearing’ before the end of financial year as funds review their holdings before 30 June, which itself typically creates some opportunities for those ready to act at short notice.
So overlaying the widening of credit spreads over the last two weeks, with the steepening in the yield curve over the same period presents some specific opportunities for our investors. As noted above, we think the best value in the curve is presenting in maturities in the 2018 to 2020 period. With spreads widening, we would also add some credit risk to take the best advantage of the current market conditions and look to add corporate credit to your portfolio. Specifically we see the best opportunities for wholesale investors in the recently issued Qantas, Lend Lease and Downer issues. And for retail investors the best opportunities are coming from DBCT, Stockland and National Wealth.
Dollar cost averaging
Often investors are concerned if this is the best time to buy. Will the curve continue to steepen next week? Will spreads continue to go wider? And as a result they will often do nothing, and if the curve becomes shallower, or spreads come back in once the market digests exactly what the Fed has said, they will have missed an opportunity.
Dollar cost averaging is a strategy which investors often apply to the equity investments. It is where you buy a particular share, or fund, or index on a regular basis in a regular amount. When the price is low you get the advantage, when the price is high...not so much. But over the longer period, you average out the risk of missing the bottom or picking the top.
Investors may wish to consider implementing the same strategy in their fixed income portfolio. Has the curve presented an opportunity today? Yes. Will it present another opportunity in two weeks time? Possibly. Investing over the investment time horizon takes the second guessing out of picking the bottom or the top – as that is almost impossible to do.
FX movement
The strengthening in the US economy, ongoing concerns in the Chinese economy and finally, Bernanke’s comments on the end of QE have also had an effect on the strength of the Australian dollar, with central banks moving money back to the default currency of US dollars (and selling ‘risk assets’ such as the AUD). However the particular concerns about the strength of China has also seen the Aussie weaken on cross rates as well, as shown in the graph below – AUD/USD cross rate in dark blue using the left hand axis, with AUD/EUR (light blue) and AUD/GBP (grey) on the right hand axis.
With global equity markets dropping, investors with foreign currency exposures may be wondering where to invest, particularly in light of most banks re-evaluating their long term FX projections for the Australian dollar.
The changes in the yield curve and credit spreads discussed above have been repeated globally, with the result being the strategy implemented above can equally be implemented off shore – with the added advantage the returns would be further enhanced should the Australian dollar continue to drop. There are a number of investment opportunities in the five year range offshore from names our investor base are familiar with and currently offering stronger returns than they were just two weeks ago.