Tuesday 18 September 2018 by Jonathan Sheridan Opinion

Time to buy or sell USD bonds?

High yield foreign currency bonds are more volatile than higher rated local currency bonds.  This journey took another turn recently as the AUD dropped to USD 71 cents. Prices on some of the higher risk names also improved last week. While not an economist or foreign currency expert, Head of Private Client Solutions, Jon Sheridan shares his thoughts on the AUD. 

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Note: FIIG does not provide FX advice or services – the following are opinions only.

The AUD/USD has spent another night hovering around the 0.71 level, and it seems it is happy to sit around here.  The question is; what to do? 

With entry levels into USD bonds sometimes well above USD80 cents, getting out at USD71 cents looks like a very compelling prospect.  I remember when we initially started suggesting investors consider USD bonds it was a conversation around diversification, as much as the likelihood that the currency would fall further.

As we have plumbed recent lows, I think this two pronged approach still holds.  I have said consistently for the last couple of years,I believe the USD will remain a safe haven currency, receiving ‘flight-to-quality’ flows if there is a significant equity/risk assets correction.  This means that while searching for yield, holding high yield USD assets is a smart policy, as the currency may cushion price falls in such a risk-off scenario.

I have been struck in recent months by the worse than usual predictive qualities of economists about the rate trajectory for the RBA, and that doesn’t lead to any further confidence in the level of the AUD.  One thing that is clear is that the US Fed is firmly on a rate hiking path, and if USD GDP remains strong and wages come to the party, we could see higher rates than the market is pricing.  Domestically, the RBA is firmly on hold, and unless we get wages growth, I can’t see us going anywhere for a long while.

This is important for the long term, as foreign currency markets are also weighing machines, to paraphrase Ben Graham.  Interest rate fundamentals drive the relative values of currencies, as money flows from lower yielding to higher yielding destinations.

I am of the view that there is more downside to the AUD/USD.  I have also consistently said, I won’t put a target on the level, but that it should be below its long term average rate of around 0.73.  The main reason for this is the fundamental situation we find ourselves in with regards to long term interest rates.  The charts below show this eloquently.

Sovereign bond curves – US and AU

Source: Bloomberg
Note: Blue line US Treasuries
Green line AUD Commonwealth government bonds

You can see here that the whole AUD government curve yields less than the equivalent USD government curve. The largest spread is at the 3 year tenor, flattening over the longer tenors beyond 20 years - I am sure this is partly due to no-one having confidence in predicting things that far out!

Spread between AU and US sovereign curves and the AUD/USD currency

Source: Bloomberg
Note: White line - AUD/ USD currency
Pink line - spread between the AU and US 10 year government bond

This shows the relationship between the currency and the spread between the two government curves shown in the first chart.  I am not reading too much into it, other than to say it looks very much like a correlation between an increasing spread and strengthening AUD, and a decreasing spread and a declining AUD. The spread has been reducing since 2011 and the currency has broadly followed.

Now, I hope I have made it clear that I am neither an economist nor a macro expert.  I try to provide sensible, fact based opinions on bond investments.  I leave the other things to those who spend their whole time looking at it.  Someone I’ve always found interesting is Raoul Pal.  Raoul is one of the founders of RealVision, the online finance TV channel - I have sent round a few things from him.

Raoul charges USD40,000 a year to hedge funds for his macro research, but thankfully also puts stuff on Twitter. This was the main reason I rejoined recently – there’s lots of cool stuff there.  On Sunday last week he put out a series of charts regarding the current dollar bull market and he included the AUD, not usually on the radar of mainstream global investors. That’s one of the reasons I like Raoul – he does truly think differently. See his commentary below:


Source: Twitter 

And another:

Source: Twitter

Particularly interesting is that the range in focus on his chart is over the same time frame as mine - from about 2000.  Raoul thinks that the AUD is about to break down under that long term support. 

Now, I am not really a believer per se in charting like this, but I do recognise many people are and it has the potential to move markets, as the market is really just a collection of opinions.  I try to look at trades where the risk is asymmetric i.e. skewed in favour of one outcome or the other, hopefully protecting the downside whilst offering good upside potential.

Conclusion

It seems to me that the fundamentals are leaning towards a lower AUD, meaning there’s potential currency upside in holding USD bonds.  The USD economy is on a bit of a tear, and the deficit there may well weaken the USD in future but it seems all the momentum is now towards a stronger dollar.  The backstop is the safe haven status I mentioned earlier – if it doesn’t end well with the Fed raising rates too high or too fast and pushing the US into a recession, which I have said before I think is likely as they’ve done it almost every time since WWII, then as AUD investors we should hopefully be protected.

So, don’t be afraid of maintaining or even adding to USD exposure at this level if the opportunity makes sense.  Yes, there is the option to come back to AUD and this may be the right call when looking at returns on particular USD bonds that have underperformed. Remember that’s why we have a portfolio – no one gets everything 100% correct. However, with the scarcity in AUD supply at the moment and some compelling offers in USD bonds it doesn’t make sense to me to sit in AUD cash when you can potentially switch bonds while staying in currency.

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