In Part 1 we explored the benefits of utilising active currency to counter the low bond yields currently plaguing fixed income portfolios. Part 2 digs deeper and looks at three factors which are making it harder for bonds to play their traditional role as the ballast within portfolios. But there is an upside: active currency is becoming a vital return source in the fixed income manager’s toolkit.
It’s rare for the vagaries of fixed income markets to make the leap into the mainstream finance media, but at times last year it was near impossible to go a week without stumbling across another article decrying diminished bond market liquidity.
The blame for this outbreak of illiquidity was aimed squarely at a new regulatory regime, the centrepiece of which was the Dodd-Frank Act in the US. This bill sought to de-risk the major US banks in the wake of the great recession. Rightly or wrongly the public blamed risk-taking by the country’s biggest banks as driving the crisis; so there was little sympathy when they were hit with increased costs for a range of dealing services.
However well intentioned, these new rules made it more costly for banks to warehouse assets on their balance sheet and it exposed the important market-making role that these firms had previously filled. A buffer had been thinned, but at the same time there has been a shift towards high frequency trading which has radically altered market fundamentals.
This was evidenced in the Treasury flash-rally of October 2014 where we witnessed one of the largest intraday fluctuations in yields of the last 25 years. Yields on the US 10-year bond fell 37bps in the morning session. While the market managed to correct itself, other asset classes were affected and it became clear that this historically liquid market had lost some of its depth and that it would likely stay that way.
The forces at play may seem contradictory; on the one hand large scale bond buying by central banks flattened yields and reduced volatility, but on the other it has led to crowded trades in illiquid assets with banks less willing to offer intermediation. In a crisis, when investors are rushing for the exits, the only way is down and liquidity dries up. This is making the work of fixed income managers very difficult.
This is where active currency comes in. Currency markets will see the same if not more volatility, but the depth and fluidity of the market will mitigate some of the congestion exhibited by the bond market over recent years. If bond markets are viewed as a lagoon that is looking parched, then currency markets are an ocean that reaches across the globe. Currency is an extra lever that is very useful in an environment where bond liquidity air pockets are more probable.
Currencies are not only highly liquid, but they’re also far less interest rate sensitive than holding bonds. For fixed income managers, with high duration assets in their portfolio, active currency can be a useful offsetting tool as monetary policy tightens and rates head higher.
The US Federal Reserve’s long-awaited lift-off of rates last month was well-telegraphed and broadly expected, the hiking cycle has begun but this puts benchmark investors in a difficult position. With yields having been pushed to historically low levels the price sensitivity of bonds to interest rate rises (duration) is high.
Holders of long-duration bonds are in a precarious position not only because yields are coming off such a low bound, but also because issuers are being incentivised to lock-in attractive borrowing rates. By going further out the yield curve issuers can boost their capital more cheaply, but those left holding the bonds will see an escalating capital loss with every upward shift in rates.
Benchmark investors beholden to long duration assets can offset potential losses by diversifying their assets into active currency.
Active FX trading is a natural addition to a globally focussed fixed income investor, the macro fundamentals that determine their investing decisions readily translate across to the FX market. With the Australian Composite Bond Index showing a duration of some 4.5 years this is more important than ever.
With a lack of consensus in the market about the pace at which the US Federal Reserve will lift rates, there is the very real chance that a hawkish Fed could take long duration bond holders by surprise, a move that would have severe consequences for those assets.
With so much attention focussed on the Federal Reserve’s rate moves, one would be forgiven for missing the growing currency opportunities emanating from the changing makeup of emerging market reserve holdings.
Looking to Malaysia, reserves have come under pressure with the Ringgit weakening against the US dollar since mid-2015. Authorities have been forced to draw-down foreign reserves to stem the spill over into inflation.
Moves like these are important but they’re overshadowed by the elephantine potential of China’s central bank slowing its accumulation of foreign exchange reserve. Observers suggest that China’s reserves peaked in June 2014 at the not insignificant level of around $US4 trillion. In fact, at 16%, the last eighteen months have seen the largest drop in China’s reserve holdings on record.
While a slowing economy has been one factor coalescing to this effect, a more powerful driver has been net capital outflows from currency interventions aimed at maintaining exchange rate stability, but also a historic liberalisation of the capital account.
This of course cannot continue forever, and in the wake of the November acceptance of the renminbi into the IMF’s SDR, speculation has risen that the Yuan (CNY) will be allowed to continue to depreciate. On top of this, just as traders started to position for long USD, short CNY, as the “trade of 2016” – Chinese authorities have highlighted a potential shift to a basket of currencies. If this becomes the target, emphasis on keeping USD/CNY stability will lessen and we can expect that depreciation to continue apace.
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