Why the market is wrong on rates

The decision by the Reserve Bank (RBA) last week to hold cash rates steady and the subsequent movements in cash and bond markets need to be noted by investors who are seeking yielding investments.

One significant move has been the continuing lift in yields across the bond curve. In particular, the Australian three-year bond saw its yield lift to above 3% (on Tuesday), which is the current RBA cash rate. In mid-2012 the three-year bond actually yielded just 2% and was well below cash rates of 4.25% at that time. At that point, money markets were anticipating aggressive cash rate cuts by the RBA in response to the diabolical debt situation developing in Greece and Spain.

Since then the European Central Bank (ECB) has declared a policy to do “whatever is necessary” to stabilise and support European bond markets. Indeed, the threat of a massive quantitative easing program has acted to push down European bond yields and dispel the threat of default. Bond traders across Europe now have a massive perceived safety net provided by the ECB. They believe that the ECB will overtly and covertly act to ensure that the cost of government debt, indicated by bond yields, will be held in check. This will ensure that the fiscal budgets of countries like Ireland, Spain, Italy and Greece will be manageable, interest paid and an orderly bond market maintained.

The result of the above is that Australian three-year bonds are not only hovering around the cash rate but are yielding higher than economic trouble spots such as the United Kingdom, Ireland and Italy amongst others. Incredibly, a five-year Australian bond yields about 2.5% p.a. higher than a five-year UK bond. An investor in a UK bond continues to invest in a security which yields below inflation, has suffered from the recent 10% currency devaluation and is issued by a government that has just had a credit downgrade. The pervasive effects of QE are starkly on show in the UK.

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What does this all mean for Australian yield securities?

The lift in three-year bond yields, the 90-day bill rate (3.07%) and 180-day bill rate (3.07%) all suggest that market participants are warming to the view that the RBA has all but completed its easing bias. This is a sharp market change from three months ago and it appears to directly correlate to the buoyant mood on equity markets.

Indeed, yesterday’s surprisingly strong jobs figures have again boosted notions of upward pressure on Australian rates .But there is plenty of scepticism in the market over these monthly figures and it is unlikely they will be significant in the longer term.

The interesting thing about the buoyancy in equity markets, here and abroad, is that it appears to be very much in response to QE. In particular, it is crucial to note that US shares now yield above US 10-year bonds and this is clearly a unique event – as unique as unlimited QE.

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So I pose this question –-is the equity market a relevant consideration in determining the appropriateness of interest rate settings in a period where there is mass manipulation of bond markets? In “normal” times bonds and equity markets would give investors and the RBA an insight into the likely future trends in economic growth, earnings growth and inflation. Today the relevance of forecasts based on these markets is meaningless, and indeed the reference by the RBA to buoyant equity markets as a “cash setting” consideration is as pointless as pointing to UK bonds!

To reiterate my point, virtually all central banks around the world have maintained cash rates at near zero. They have done so for four years and the effect of this policy in terms of economic growth has been negligible. Indeed, in Europe it has not been enough to stimulate any sustainable growth at all – except in Germany.

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I conclude from this that the market is probably wrong in not expecting at least one more cut before June. The continued strength in the $A, the forecast slowing in the resource-focussed capital expenditure cycle and moribund state of the Commonwealth government in pushing forward with infrastructure development (bar the NBN), suggests that our economy is not going to jump a gear. Indeed the recent reporting season actually led to consensus forecast earnings declining for the whole market in 2012-13. So equity markets may be buoyant, but it has little to do with earnings at this point.

Income Portfolio

The good news for our portfolio is that the lift in the yields for 90 and 180-day bill futures suggest that current floating-rate yields should hold at current levels through the net interest payment period through April. That will actually be a sort of windfall if indeed the RBA cuts 25 basis points again before June, because investors in floating-rate securities could hold a quarterly payment unadjusted for a belated cash rate cut.

However, from a longer-term perspective, I maintain that the $A is overvalued and there will likely be a devaluation against the $US and Chinese yuan in 2014. At that point inflation will reappear and the RBA will likely move cash rates back up to possibly 3.5% by late 2014.

So what are the buy prices on our preferred income securities?  

The four major floating-rate securities in our income portfolio are noted below. What I have done is forecast the next four quarterly distributions from each and provided a forecast yield based on current prices for calendar 2014. Then I have suggested prices that these securities should be considered for accumulation. In doing so, readers should note that the securities are constantly accruing income up until their ex dates and thus these valuations move over time. 

John Abernethy is the Chief Investment Officer of Clime Investment Management.

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Clime Income Portfolio

Return since June 30, 2012: 23.02%

Returns since Inception (April 24, 2012): 21.78%

Average Yield: 7.75%

Start Value: $118,757.19

Current Value: $146,091.02