David Ashton, Senior Portfolio Manager
Thursday 22 March 2018
The bond market event not seen since the turn of the century
David Ashton, Senior Portfolio Manager
The first two months of 2018 was a difficult time for bond markets.
Yields moved higher, and commentators were rushing to call the end of the 30+ year bond bull market. One of the key arguments has been the sharp increase in supply for the market to take down, at the same time as central banks globally reducing their bond buying programs.
Rising bond supply has not been uniform across all markets however – creating opportunities for investors.
US increasing budget deficit, and supply of bonds
In February, the US Office of Management and Budget updated deficit forecasts to account for the impact of tax cuts passed in December 2017. These forecasts predict the deficit will rise towards $US1 trillion in the 2020 financial year, up from the post-crisis low of $US438bn in 2015.1 This should result in increasing bond supply from the US Treasury. At the same time, the US Federal Reserve (Fed) is allowing its balance sheet to reduce gradually, meaning they will be buying less of the bonds being issued.
US Federal budget deficit
Source: US Office of Management and Budget
So far, the US Treasury is funding the bulk of the increased borrowing requirement through shorter term debt. The most notable impact on US markets has been the rising spread between the bank funding rate, as indicated by the three month London Interbank Borrowing Offered Rate (LIBOR) which now sits above 2%, and the market implied path for Fed Funds, through the Overnight Index Swap (OIS) market.
This widening spread differential has been exacerbated by reduced demand for short-term assets by US corporates, who have been repatriating offshore earnings in response to the tax cuts. As a result there is a potential crowding out effect, whereby issuers are having to pay a greater premium to entice investors in that part of the market.
Libor OIS spread
Australia’s decreasing budget deficit, and supply of bonds
Meanwhile, the Australian Mid-Year Economic Update (MYEFO) published in December 2017 showed an improvement in the fiscal position by $A9.3 billion over the forecast horizon compared to the May 2017 Budget.
Issuance forecasts from the Australian Office of Financial Management indicate a net borrowing requirement of $A32 billion in the current financial year, compared to $A81 billion last year.
Furthermore, the monthly financial statements for January showed the fiscal balance is already $A6.4 billion ahead of the MYEFO forecast.2
Notwithstanding the monthly volatility of this data, it appears the budget position is continuing to improve and likely alleviates some of the ratings pressure implicit in the negative outlook from Standard & Poor's (see our previous insight from January 2017 here).
Spread inversion – not seen since the turn of the century
While this has investment implications across all asset classes, one clear impact has been on the narrowing and subsequent inversion of the Australian 10 year yield spread to US Treasuries for the first time since 2000.
Of course this has been aided by divergent monetary policies, with the US hiking cycle well underway and likely to continue throughout this year, while the Reserve Bank of Australia has signalled patience in responding to the improving outlook.
We believe this supply divergence has been an important factor in attracting strong foreign buying of Australian government bonds.
10 year yield differential Australia versus US
As the change in government fiscal positions tend to persist, it would be unlikely we see the divergence change anytime soon, continuing this spread inversion. However, we ultimately believe an inverted spread to be unsustainable over the longer term due to Australia’s persistent current account deficit, as well as its higher potential growth and neutral cash rate. As such we would be looking for signals of shifts in these dynamics as an opportunity to take advantage of a widening spread.
The other market impact domestically is evidenced in the difference in price (basis) between the bond futures and the underlying basket of physical bonds or the futures arbitrage. Since 2009 when the supply of government debt in Australia increased significantly, physical bonds have traded structurally cheap to the futures contract. Improvements in the supply outlook have worked to reduce this basis recently, but there remains a performance drag by owning futures in a portfolio. We would expect continued improvements to erode this basis further, however, there are significant positions held by hedge funds and other leveraged investors that are likely already being unwound which should keep futures slightly expensive to bonds.
3 year Australian bond versus futures price
The increase in government bond supply in the US is having an impact on financial markets, but the experience in Australia is different.
Looking ahead, the improving relative budget position in Australia is likely to create long-term opportunities for investors able to trade the relative bond spread with the US.
Finally, while the performance drag from owning futures to hedge duration has diminished in our domestic market, it is still apparent and will continue to have implications for portfolios hedging duration through futures.
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