Fixed Income

Has it really been 20 years since Y2K fears gripped global markets? To combat the turn of the century and fears around potential technology issues (as computers rolled from 1999 to 2000), the US Federal Reserve (the Fed) flooded markets with excess liquidity to help the plumbing of financial markets to the tune of $120 billion, which in the day was a very large amount – more so than the support it provided after September 11th terrorist attacks. This special lending facility ran from October 1999 through to April 2000, during which time some risk assets had an almost exponential rise in value. When the program ended in April 2000, the NASDAQ crashed 25% the following week.

This may be almost a story for the grand kids some 20 years later, but it matters because it highlights how difficult it has been for policy makers to extract themselves from markets. We have just experienced a significant, but obscure policy intervention again from the Fed that many investors have never heard of, but it is due to end in Q2, 2020 and there are material parallels in recent market behaviours. So how did we get here?

When the Fed hinted in late 2018 that it was going to increase interest rates several more times in 2019, and the balance sheet reduction was on automatic pilot’ in order to unwind the excess of multiple QE programs, the S&P 500 Index plunged almost 20% and recession fears became prevalent. This forced the Fed to flip in early 2019 to being ‘patient’ in response (code for the end of rate hikes and start of a possible cutting cycle) and risk markets took off and haven’t really looked back. Ironically, until the middle of the year more than half of 2019 equity gains were delivered on two days, when Fed Chair Powell delivered material policy support, being January 4th (Fed is ‘patient’) and June 4th (the Fed will ‘act as appropriate’), on both days equity markets gapped significantly higher. Whilst we did see multiple rate cuts starting in July 2019, the balance sheet reduction had continued, but by September 2019 markets had a mini seizure, with overnight repurchased funding rates (repo) blowing out to more than 10%.

This caused the Fed to immediately step into funding markets and launch a blistering program of support and balance sheet expansion. In doing so, it added more than $400+ billion USD to calm repo markets, with the focus being on the year end period due to heightened concerns around liquidity. The Fed’s reaction to the disruption in repo markets shows how hard it will be for policy makers the world over to reverse their money printing. This policy is due to run until April, but as yet no communication has been delivered on how this might be wound down, or if it may extend. The Fed could let the repo program expire if it believes the risks to funding have subsided, or they could keep it running but add some flexibility by charging higher rates to access such a facility. Either course would essentially make the market end its liquidity fix, risking an abrupt turn in market sentiment. Alternatively, the Fed could hold its balance sheet steady or continue to add liquidity, providing risk markets with further tailwinds. You may not have heard of ‘repo’, but it is a critical piece in the jigsaw to watch in 2020.

December bond market moves are significantly out of line with our Australian RBA view.

In many respects Australia seems out of sync with global economies (multi-year laggard) and may be suffering a mild but silent private sector recession.

Over 2019 the economy enjoyed three RBA interest rate cuts, significant tax cuts, status quo property and equity market investor policies (negative gearing and franking) and surging terms of trade, and yet the economy is just only limping forward, well below the RBA stated policy objectives. In fact, ex-Government expenditure private sector numbers look pretty woeful in Q3 GDP numbers, with equally weak numbers so far in Q4 partials data releases. Added to this is crippling drought conditions in much of the agricultural heartlands and material fire threats coming into summer. JCB believes the RBA will likely cut again in February 2020 and again by end of the first half of this year before our own Australian QE conversations start in the second half.

This makes the underperformance of Australian fixed income markets somewhat head scratching in December, and we believe there will be a material buying opportunity coming into a fresh investment year, one that still faces significant economic challenges and is likely to garner additional RBA policy support. No doubt poor year end liquidity and lack of risk appetite contributed to much of the December moves, helped along by an offshore momentum community looking for a quick profit. At the time of writing, around half of this move has already been reversed in the opening few days of 2020.


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