What US monetary policy means for Aussie investors

-- | 14/06/2018 Text size Decrease

Richard Quin: Probably two years ago, we started to go short interest rate risk. So, where most people have long interest rate risk in their portfolio, we were very concerned that interest rates were way, way too low. They were very low because monetary policy kept them low and also because quantitative easing allowed central banks to buy bonds and keep interest rates very low. We think there is a reversal of that going on and that's the double-barrel that we think you are going to see and we are seeing interest rates going up and the reversal of QE. Now, on top of that, we've also had procyclical stimulus from the U.S. with these rate cuts. Now, this is very unusual when you've got a U.S. economy that's definitely at full employment and is having trouble filling a lot of skilled jobs. So, yeah, it's playing out and just last night we saw the U.S. Federal Reserve raise interest rates now to 2%. Duration, it's a bit of cheats way of calculating a change in net present value of bonds for a change in interest rates. So, I'd say, for the Australian bond market, the Australian bond market is approximately a five-year interest rate duration market and the global bond market is approximately an eight-year duration market. Now, what that means is, for a 1% move in interest rates in the global bond market, you get an 8% move in the capital value of the bond. So, an example would be, 1% increase in rates would see an 8% capital loss in global bonds. But likewise, which we've seen in the past few years, we have seen decreases in bonds and they've given you great capital gains in bonds. So, again, that's the way the metrics sort of work. So, I'd say, if you're getting a 2% yield in Australian bonds and you get a 1% increase in interest rates, over the year, you'd get that 2% yield, but a 1% increase would lead to a 5% capital loss. Cut it all down, you'd probably make a 3% loss in those bonds for a 1% increase in rates. Yeah, sure. And I want to be very specific in that, too. A lot of people will say when they are short duration, they are talking about being short benchmark. We have been and still are outright short interest rate risk. And we can do that in many different currencies. So, we are not just a little bit less than the benchmark. We are outright short, which has made us one of the more active managers in the space. And we got to a slightly – just over negative three years' short duration at a maximum level. We are now less than two-and-a-half years' short duration. Now, the way we achieve that – there's three ways we achieve that. One, through selling bond futures. Mainly, we do that in the U.S. We can also pay fixed with interest rate swaps and that's a method that a lot of corporate treasurers use. And then the third method we use is we use swaptions and swaptions are an option to pay fixed. And when you have credit and bond instruments that have duration, if you hedge by more than that, you take away the duration and then if you hedge by more again, you make it negative duration and that's what we've done to protect capital for the investor. And that's the most important thing. As interest rates go up, you make that capital loss. One of the things that has been happening as well over the last few years is we've seen strong credit markets. And just like in the interest rate markets, we have been short interest rate risk. And as interest rates are rising, we are getting rid of that short duration position. We've been very long credit risk, because in an improving environment when interest rates are increasing, companies are usually performing better, their earnings are better and that means also that credit spreads can contract as the risk of that company decreases as their earnings improve. So, we've taken a reasonable amount of credit risk which we are currently pairing back slowly. But again, these are gradual things. But corporate credit has performed very well and in actual fact, is still providing very good credit spreads relative to pre-2008 levels.