By Craig Simpson
Markets are said to run on two things; fear and greed.
For the first five months of 2013 greed ruled supreme. But then markets were turned upside down in June as fear took hold, US Fed Chairman Ben Bernanke giving markets their clearest signal yet of a possible timetable for tapering back the US stimulus program (quantitative easing or QE).
Failure to communicate
The 'QE drug addicts' who up until now have had their regular monthly fix via the Fed's bond buying program, reacted violently to the news. Fed Governors subsequently spent the back end of June in what I would call 'damage control mode' to try and calm down their patients.
It would be fair to suggest the prospect of going cold turkey and suffering excruciating QE withdrawal symptoms freaked plenty of investors out.
If only these same investors had read the small print rather than the sensationalist headlines there would not have been the same panic.
As Richmond Fed President Jeffrey Lacker said in an interview with Bloomberg Television, financial markets got a little bit ahead of the central bank's thinking. Lacker added that the Fed was nowhere near shrinking its balance sheet.
JPMorgan remarked that the FOMC meeting provided further evidence of the power of central bank talk, and it went further to point out the difficulties central banks have in communicating effectively and credibly. Given the amount of rhetoric and soothing words coming from central bankers, plus the reaction of investors, you have to conclude that despite its best efforts the Fed missed the mark with conveying its intentions to the market.
The Fed tapering sideshow was superceded by reports of a potential liquidity squeeze and potential financial crisis in China. The rates banks charge to borrow from each other eased after jumping into double figures amid rumours the central bank had pressured lenders to release funds.
The People's Bank of China (PBoC) called on financial institutions to improve "awareness about preventing risks" and to "strengthen their analysis and forecasting about factors affecting liquidity".
PBoC claimed liquidity in the domestic banking system was at reasonable levels, which signalled it would not inject more liquidity into the system. The central bank asked lenders to prudently manage liquidity risks that may result from overly fast credit asset expansion.
Chinese policy makers refrained from injecting more liquidity into the system, principally owing to fears about a growth of bad debts, which were beginning to weigh on the economy.
Should investors bail out of bonds?
Bill Gross of PIMCO, the world's pre-eminent bond manager shares his words of wisdom below. Pity some of his own investors have ignored his advice as nearly US$10 billion has been withdrawn from PIMCO's funds. The PIMCO Total Return Fund has also recorded its largest quarterly loss since the fund's inception in 1987.
Gross thinks bond investors should not jump ship for the following reasons:
1) The Fed’s forecast of the economy that prompted tapering panic is far too optimistic. If 7% unemployment is tapering’s final port of call, we simply think that we’re much further away than the Fed’s compass would suggest. We argue for structural headwinds – demographic, globalisation, and technology influences – that have had and will continue to have dampening effects on domestic and global growth. The Fed, we would argue, is too cyclically-oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1.5% in the last six months and the average monthly check for a new home buyer is up by 20%–25% as well, then as I tweeted several weeks ago: “Mr. Chairman are you serious?” Growth will be negatively influenced.
2) Inflation, according to the Fed’s own statistics is running close to a 1% pace. The Fed has told us that they “target,” “ target” 2% and for the next 1–2 years are willing to accept even 2.5% until they reverse engines. Fed Governor Bullard of the St. Louis Fed was in our opinion correct where he dissented from the majority decision several weeks ago, citing the distant shores of 2%-plus inflation and the seeming inability to even move in that direction.
3) Yields have adjusted by too much. While TV and the press focus on 10-year Treasuries at 2.55% as their guiding star, subjective stabs by yours truly or anyone else are difficult day-to-day. The technicals, as Mohamed has written, can dominate while the fundamentals are flushed to second page priorities. When analysing the fundamentals though, I like to point to a “North Star” that is as permanent as possible within the context of current market instability. Tapering aside, if the Fed has consistently informed the market that its policy rate – Fed Funds at 25 basis points – will stay there for a substantial period of time even after the end of QE, then to my eye, Fed Funds will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%-plus inflation. I wonder if we can get there in this decade to tell you the truth. But the beauty of this North Star Fed Funds sextant is that it can be rather directly observed in futures markets, either for Fed Funds or for Eurodollars, which are a close companion. Right now, Fed Funds futures markets are predicting a 75 basis point yield in 2015, and Eurodollars validating a similar conclusion. That would suggest a mispricing, despite the obvious caveat of professional observers that some of the 75 is a surcharge for potential volatility. In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves – the 10-year Treasury – may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%.
Smoother waters back home
NZ and Australian central banks decided to keep their official cash rates at current levels. The RBNZ again re-iterated its concerns about the impact of rising house prices (and household debt levels) on financial stability. In a separate speech by Deputy Governor Grant Spencer, he stated the RBNZ is likely to introduce loan-to-value restrictions (LVR) on new bank lending later this year.
The RBA still retains an easing bias and the market widely expects rate cuts will come shortly in an effort to stimulate the non-mining economy and turn around Australia's fortunes.
One of the issues facing NZ investors is reinvestment of approximately NZ$525 million worth of bonds that mature this month. I wrote about this issue recently and with a reasonable level of uncertainty in markets I am guessing a good portion of this money will end up in bank term deposits, as opposed to being reinvested into other fixed income securities. Investors requiring income will be struggling to find anything available that is comparable either on interest rate or possibly credit quality.
Market performance indicators
The severity of the bond sell-off in June meant many of the market indices recorded negative returns for the month.
Of the indices we follow, the NZX Government Bond Index was the hardest hit, with a return for the month of -2.2%. Over the past three months the same index was down by a similar amount.
Corporate bond indices fared slightly better and the NZX A Grade Corporate Index managed a 0.26% return for the past quarter.
The only bright spot during June was the performance of the Cititgroup WGBI unhedged in NZ$, which recorded a positive return of 2.65%, and 5.28% for the quarter. However, this index has recorded a negative return over the past 12 months, primarily because it is unhedged and the NZ$ has depreciated against other major currencies.
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