In the AFR today I dwell on the doves' case apropos "low rates for long" and, in particular, engage with the lord of the domestic bond "bulls", Charlie Jamieson, who is uncompromising in his evisceration of the bond "bears" as represented by the likes of Tim Toohey and Brett Gillespie at Ellerston Capital (click on that link to read for free or AFR subs can use the direct link here). Excerpt below:
"One of the most vocal local bulls is the barrel-chested Charlie Jamieson from the eponymous Jamieson Coote Bonds, which after launching in 2014 now runs $455 million. (I played in the same rugby team as his lofty co-founder, Angus Coote, who was a handy second-rower serviced by an extraordinarily capable hooker.) "The sell-off in fixed-rate bonds won't be anything like what the bears naively assume," Jamieson retorts bluntly. "Our major secular thematic is that interest rates don't do very much for at least three to five years." Jamieson believes that after a multi-decade decline in short-term rates, which has compelled an unprecedented build-up in household debt, it is "unlikely funding costs will reverse quickly". "Escape velocity in the economy is inherently difficult to achieve with elevated debt burdens and it is much more probable that we have an elongated consolidation phase in this rates cycle," he says. The no less dovish Coote cites the case of Canada where the central bank has lifted its cash rate twice this year only to "push house prices down 23 per cent and force the economy to materially slow". Surely this will exercise Martin Place's collective minds after blowing the mother of all housing bubbles with munificent policy settings since 2013! Jamieson argues that in any hiking cycle, the total return damage is ordinarily inflicted before rates rise as a result of longer-term expectations adjusting quickly. "We saw this in Australia in the fourth quarter of 2016 when the fixed-rate Composite Bond Index, which has five years of interest rate duration, slumped 2.9 per cent," he recalls. (Over the last 12 months the Composite Bond Index has suffered a 0.75 per cent total return loss after it shrunk 33 basis points in September.) Precedents supporting JCB's proposition include the US Federal Reserve's last hiking cycle in 2004 when it boosted the short-term cash rate by 425 basis points. "During this episode the long end of the yield curve – as proxied by 10-year treasuries – only climbed 37 basis points because the terminal cash rate and the corresponding inflation expectation were well-priced," Jamieson notes. He adds that while the Fed has already hiked 50 basis points this year (I expect a third hike in 2017), 10-year yields are 30 basis points lower. "Any fixed income strategist worth their salt knows the market has historically 'bear flattened', with long rates hardly budging, once the 'hiking begins' because that's past the point of maximum inflation expectations," adds Coote. A challenge for bond market "shorts" is that they can be cannibalised by negative income carry, or interest they pay on their positions. Such an exposure in 2017 would have lost over 5 per cent in 10-year US treasuries alone, JCB claims. The higher interest elasticity of demand wrought by the big increase in household leverage since the last inflation cycle in the 1980s rationalises JCB's view that central banks have misjudged their terminal cash rates. In Australia Jamieson puts the RBA's "neutral" cash rate at 225 basis points, or only three hikes above its current all-time nadir, and five hikes below the RBA's estimate of the new neutral at 350 basis points. He is similarly critical of the Fed's terminal cash rate, as represented by the peak in its "dot plot", which he describes as "overly enthusiastic" at 275 basis points. The performance of fixed-rate bonds over the next few years hinges heavily on who wins this debate. If JCB is right, now could be a good time to buy. The alternative perspective outlined by Tim Toohey and Brett Gillespie at Ellerston is that long-term yields could jump 130 basis points if the unwinding of asset purchases by central banks drives a normalisation of demand and supply dynamics and mean reversion in the artificially suppressed cost of capital. Jamieson dismisses this view: "Central banks spent US$14.5 trillion to engineer the global recovery and have unlimited firepower – betting against them is futile." "Bring on the hikes both here and in the US," he continues. "This will conclude the economic and asset cycle nicely and bequeath us the conditions I love investing in: Armageddon." I don't take any of these first-order interest rate risks in my own portfolios based on the belief that the pricing of rate probabilities tends to be efficient. It is, as a consequence, hard to get an edge that consistently beats the market. I am nonetheless of the view that the long-term risk-free discount rate is higher than markets, central bankers and doves like JCB allege and that inflation, not technology-induced disinflation, will emerge as a governing narrative in years to come." Read full article at AFR here.
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.