The 90 day tariff imposition freeze announced last week certainly helped to stabilise asset markets, but it did not trigger a material recovery in either the bond market or the various equity indices. A lot has been written about the increased volatility of all asset markets over the past fortnight and investors need to remain cautious. When in doubt stay out!
At this stage we are assuming:
- Trumps intention is to force countries to come to the negotiating table;
- An across the board minimum 10% tariff on all US imports will be used to raise revenue to improve the US budget outcome;
- When the current correct elasticity of demand and price is imputed into the tariff calculations the outcome (determined at the negotiating table) will be ex-China no more than 14% on average;
- The purpose of the tariffs, and what is looking like a trade war or deglobalisation, is really about addressing the unfair trade and business practises employed by China under its communist form of government, where factors of production are organised centrally;
- The timing of the 90 day postponement of the tariffs was to avoid impacting 2 very big treasury re-financing auctions. Fortunately, both the 10 year (with 22 billion issued) and the 30 year (with 32 billion issued) auctions were successful;
- It is not possible to draw definitive conclusions on which investors turned up to the US treasury auctions, however given the lack of a recovery in the US dollar we are confident it was mainly US domestic banks and fund managers. This would explain why the US 10 year yield traded as high as 4.58% on Friday night before closing at 4.50%. The street is now caught out long bonds at a time when offshore demand is absent.
Last week we said that the tariffs were certainly inflationary, but the growth outlook was murky. The bond markets came to the same conclusion with the US 10 year yield surging 50bps to close at 4.50%. There is, however, one off ramp from the inflationary path and that is the USD rising enough to offset the tariff price impact. This has not happened yet and in fact the USD has so far been weaker. The dollar weakness will compound the inflationary impact of the tariffs. We need to see the USD above DXY 110 before we can even begin to relax about US inflation.
We also need to consider the impact on the shipping industry of Trump insisting that shipping companies abide by the US sanctions. Shipping companies will need to shift their resources from China connected trade to other parts of the world if the China-US trade war results in trade collapsing, but there is also a risk that many of these shipping companies will be banned for involvement because they were involved with undermining the US and Euro sanctions on Russia. There is increasingly a risk that the US supply chain seizes up in much the same way it did in the pandemic.
One of the reasons – incorrectly- given for the spike up in yields was the unwinding of the ‘Basis Trade’. The mechanics of the basis trade should be well understood by Australian investors that have bought the raft of funds portraying themselves as a fixed income ‘alternative’ but are really gearing on gearing Ponzi schemes.
Basis Trade
1. The asset managers gear their portfolios by buying Treasury futures instead of the Treasury bonds. This is possible because you only have to put down an initial margin to buy the Treasury future.
2. Hedge funds recognise that this selling activity by asset managers has Treasury futures trading a t a 2-3 bps premium to the underlying Treasury bond. A hedge fund sell short treasuries and buys treasury futures for an almost riskless arbitrage.|
3. The hedge fund that has put down say $10m of Treasuries to sell $10m of Treasury futures still has about $9.9m of unencumbered treasuries that it can lend into the repo market. They then buy another $9.9m of Treasuries and sell $9.9m of Treasury futures against it. They keep repeating this process to reach their target returns. Typically, a hedge fund would be leveraged 50 times, but some have been much higher still.
4. Now when treasury volatility spikes – as it did last week – the margin on the sold futures contract spikes & the repo lenders demand a big increase in collateral. Then the hedge fund cannot deliver this collateral the lenders seize the Treasury bonds of the hedge fund and sell them into the market.
This type of rapid unwinding of leverage did not initiate last weeks spike in yields, but it certainly accentuated it. There is estimated to be currently some $800bn of basis like trading strategies using the US Treasury bonds. There would also be a lot of pressure on the swaps market where again the spike in volatility would require more collateral (margin calls) and some participants will have been forced to just close out their positions.
This is something we have seen before:
- LTCM ran long positions in new treasury issues using gearing and then also shorted the most recent existing treasury. When volatility spiked the Ponzi scheme collapsed 1998;
- The GFC triggered by a spike in volatility forcing one bank close its positions and this cascaded into the crisis;
- The failure of the UK Truss Budget in November 2022 brought about a spike in volatility that forced leveraged players to rapidly unwind their positions and this spiked yields up.
- In March 2020 the rapid fall of non-US currencies forced offshore holders of US Treasuries to dump their bonds and yields spiked. This forced the Federal Reserve to enter the market.
Interest Rates
The US 10 year yield surged 50bps to close at 4.50%. This was the largest weekly rise in more than two decades. It traded on Friday night as high as 4.58%. This rise was triggered by the market realisation that the tariffs are inflationary in the US. 12-month inflation expectations surged to the highest level since 1981. The US 2 year yield rose from 3.74% to close at 3.97% despite better than CPI data as a result of the fall in the oil price since Trump was inaugurated. Federal Governor Collins plainly said that an interest rate cut was an unlikely response given the uncertain implications of the tariffs.
Australian 10 year yields rose from 4.09% to close on Friday in Australia at 4.37% but they will open on Monday at 4.44% (NY close). The 2 year yield fell from 3.40% to 3.25% despite RBA Governor Bullock stating that an interest rate cut is an unlikely outcome from the tariff induced market volatility. The market may re-assess its confidence in 4 rate cuts in 2025 when the 2 year opens trading on Monday near its NY close of 3.39%. Australian yields are just a passenger with the US rate volatility.
Major Credit Markets
All credit markets were again quite volatile. The prime example of US investment grade (IG) was a roller coaster with risk market moves. At the end of the week IG credit was only slightly wider than the week before despite a 13 point range, this alarmingly representing nearly 20% of the spread.
Something of a trading vacuum opened up in the Australian credit market last week. There was no issuance of significance and just selling from leveraged fund managers. Major bank 5 year margins spiked out to 100bps but it was in the Tier 2 bond market where 50bps moves were seen and little actual trading achieved. It is likely that the investment and trading banks with tight stop losses on their principal books were stopped out late the previous week and so were absent from the market last week. If the US market volatility persists then we are likely to see a rapid unwinding of leveraged Tier 2 exposure by Australian funds. The Aust. iTraxx rose by 0.10% for the week to 1.06%, however may ease given Fridays IG spread drop in the US.
High Yield Markets
As expected, the US high yield (HY) was volatile again with the extra damage of huge outflows from HY funds. Further no new HY bond IPOs were conducted and even very few in the IG market. At week-end HY spreads were tighter than the week before, tracking the up move in US equities for the week. Selling in HY and Junk bond ETF’s has compounded the problem, ETF’s simply wanting to transact, making them fodder for credit traders.
After the huge jump in hybrid margins week ending April 4, the major bank average hybrid margin eased back 0.18 % last week to finish at 2.33%. Panic selling looks to have abated with daily volumes falling from 2x on Monday to just above average on Friday. NAB hybrids led the volume, being 30% of major bank hybrid trades, in particular NABPH (Dec 27 maturity) with $18m traded. Longer term issues were also amongst the highest volumes.
The $1.3bn CBAPG redemption funds hits accounts on Tuesday April 15. Funds from AN3PH recently did flow back to the market, we expect CBAPG funds will also.
Listed Hybrid Market
Hybrids – a long look back
At times of market volatility we look for long term yardsticks to assess current markets, especially for sectors that are in reality driven by larger markets, such as hybrids to the senior bond market. The iTraxx index represents the largest 25 Australian senior bond issues and is compared in the chart below to the major banks average hybrid margin (note the Y axis scale differences). The chart goes back to 2013 and shows several times of quick margin rises. In context, the current rises are well within previous ranges. To compare relative value, the second chart is a simple ratio of the two. The last data point shows hybrid look expensive relative to the iTraxx on both a long-term basis and since 2022, a time after which hybrids did trade in a tighter range. Investors should watch how the iTraxx trades in coming weeks.
Forward Interest Indicators
Australian rates
Swap-rates show large volatility with bond market rates rate, overall swap rate rise
Swap rates:
– 10-year swap 4.34%
– 7-year swap 4.07%
– 5-year swap 3.84%
1-month BBSW 4.08%
