Bloodbath on Threadneedle Street

Christopher Joye

Coolabah Capital

In the AFR I wrote that September has been a bloodbath for financial markets, driven by a range of shocks including a more hawkish than expected US Federal Reserve, upside surprises to inflation around the world, and then new UK prime minister Liz Truss blowing up her own bond market and the pension funds that invest in it with profligate fiscal stimulus that required an extra £45 billion ($75 billion) in public debt issuance.

Back in December 2021, the 30-year British government bond, known as a “gilt”, was paying an interest rate of just 0.8 per cent. In price terms, the 30-year gilt was trading at £111. Fast-forward nine months and the interest rates on 30-year gilts hit about 5 per cent at one point in September, up almost 200 basis points from 3.2 per cent 27 days prior (or up 420 basis points from December).

It has been a truly astonishing move that has cratered the price of the 30-year gilt down by an incredible 61 per cent from £111 to £43.

Coolabah doesn’t bet on interest rate changes or shifts in central bank policy rates, and we hedge all our interest rate risk into floating-rate, rather than fixed-rate, format.

We had, however, commenced aggressively hedging and shorting “credit”, which includes bank and corporate bonds, immediately after Fed chair Jay Powell’s Jackson Hole speech on August 26, and upped the size of these hedges/shorts to over US$700 million following the surprisingly high core US inflation print and the release of the Fed’s hawkish dot plots that quantify the central bank’s expectations for rate changes.

Since US and Euro credit spreads had moved sharply wider in September, these shorts/hedges had accumulated material gains by Wednesday, and we started taking profits. Then the Bank of England tape bomb hit the screens.

The huge increase in gilt yields, and the even more striking reduction in gilt prices, had inflicted massive losses on UK investors. This was forcing them to sell other, more illiquid, assets around the world, including their holdings of Aussie residential mortgage-backed securities (RMBS), to meet margin calls on derivative exposures, creating a chain reaction across all markets. There was fevered speculation that some UK investors could default on these derivatives as a result of their inability to sell the illiquid collateral backing them.

On Wednesday, the Bank of England shocked investors with a sudden intervention. It announced it would buy up to £5 billion of 20-plus-year gilts every day until October 14, taking £75 billion of long-dated debt supply out of the market. This was conveniently much more than the £45 billion debt shock triggered by Truss’s tax cuts.

The BoE further stated it would buy whatever quantity of bonds was required to restore order and liquidity to the otherwise unprecedented volatility in the gilts market, which furnishes the risk-free rate for all UK business and household borrowings. The huge swings in the interest rates on gilts was making it hard for UK banks to price mortgages, which in turn risked morphing into a credit rationing crisis.

As soon as we absorbed these headlines, we took profits on all our shorts globally, expecting a risk rally. Truss blowing up the UK bond market had adversely affected all asset classes, including Australian and US equities. If the BoE could immediately restore order, this should have been well received by investors.

The BoE was careful to explain that this was a temporary financial stability intervention that would ultimately end up with the central bank selling the bonds it bought back to the market once conditions normalised.

It argued that it was not seeking to provide funding for the politicians’ deficits nor targeting a specific level of long-term yields. It was simply focused on the financial stability risks of Truss blowing up the UK pension system.

The truth, however, is that all central banks are trying to set both short- and long-term borrowing rates through their monetary policy levers. While the BoE adjusts its short-term bank rate in the same way the Reserve Bank of Australia does its cash rate to influence both variable and fixed rates along the government bond yield curve, it’s worth noting that longer-term borrowing levels are more important to central banks like the BoE and the Fed in economies dominated by fixed-rate, rather than floating-rate, debt. In Australia, most loans are floating-rate, which means the RBA’s monetary policy changes are inherently more focused on shorter-term, rather than longer-term, interest rates.

The gilts crisis had massively increased long-term rates beyond the BoE’s expectations, and in time it could choose to de facto target a long-term yield that is more congruent with its monetary policy preferences. In this way, the BoE could continue to hike its short-term bank rate aggressively (which it is bound to do in the months ahead) while having the option to do more bond buying (or quantitative easing) further out the curve to secure a level of rates that is still highly restrictive, just not so punitively punishing that it exceeds the BoE’s objectives.

The first BoE bond purchase auction held on Wednesday afternoon was a resounding success, and 30-year gilt yields collapsed by more than 100 basis points on this day alone. The BoE only bought £1 billion of bonds, and the offers were paltry at just £2.5 billion. Even less was offered up by the market on Thursday, even though the BoE was paying gilts prices that were 23 per cent higher than those investors were accepting one day earlier. The BoE had called the market’s bluff and won, at least for the time being.

Monetising our global shorts/hedges proved to be the right decision on the day as equities and credit indices started to rally slowly with the S&P 500 finishing up 2 per cent by the end of the session. It was nonetheless clear in the following day’s session that markets wanted to look through the BoE as the S&P 500 gave back the prior day’s gains. Given the availability of more attractive entry levels, we have reestablished some of our credit shorts/hedges.

US stocks have shed about 8.5 per cent in September so far. Aussie equities are not far behind. The yield on the US 10-year government bond has soared from 3.19 per cent to 3.97 per cent. Australia’s 10-year government bond yield has similarly jumped from 3.60 per cent to 4.10 per cent, notably still below the 4.20 per cent peak in June.

The great Aussie house price correction also persists with gusto. National capital city prices have slumped another 1.3 per cent in September, bringing the peak-to-trough drawdown to 5.7 per cent. Based on the last quarter of data from CoreLogic, national metro prices are falling at more than 16 per cent a year.

In Sydney, home values are on track for a third month of circa 2 per cent losses and have plunged by more than 9 per cent from their recent peak. They are correcting at 22 per cent a year. After defying gravity for a few months, Brisbane prices are tanking, dropping 1.7 per cent in the first 29 days of September after falling by a record 1.9 per cent in the month prior.

It is a more subdued story in Melbourne where dwelling values have “only” dropped by another one per cent so far in September, bringing the peak-to-trough loss to more than 5.6 per cent. Melbourne prices are melting at 14 per cent a year.

My old friend and News Ltd opinion writer Terry McCrann recently criticised this column and the website MacroBusiness for drawing attention to what we believe will be the greatest decline in Aussie house prices in history.

When we first published our projection for a 15-25 per cent correction in national house prices after the first 100 basis points of RBA rate increases, we clearly noted that this would be in the context of the spectacular capital gains that we had predicted back in March 2020. I wrote that since the end of the 2017-2019 housing correction, “capital city home values have climbed by a robust 30 per cent”.

“The capital gains after the much milder COVID-19 retrenchment have been 21 per cent,” the column continued. “Going back to the end of the 2010-2011 downturn, we find that homeowners have profited from a 72 per cent increase in the value of their most important asset.”

This column has repeatedly stressed that the RBA normalising borrowing rates would inevitably drive some “payback” of these stunning returns, asserting that “what Martin Place giveth, it takes away” because changes in lending rates have an enormous influence on borrowers’ purchasing power and the prices they can afford to pay.

While McCrann does not like us describing the largest drop in Aussie house prices on record as a “crash”, that is precisely what it is. By definition, almost every asset price collapse is preceded by unusually strong returns, as any crypto junkie will breathlessly explain. Accurately forecasting these outcomes is incredibly important for households given that residential property represents half of all their wealth. CoreLogic’s daily house price indices also provide one of the few real-time measures of the impact of the RBA’s 225 basis points worth of rate increases. I will have to respectfully disagree with McCrann on this point.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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