Wednesday 02 December 2020 by Jonathan Sheridan 2020-recap-800 Opinion,Commentary

2020 - a year no one will forget...

For the last “real” edition of the WIRE for 2020 we thought it would be a good idea to recap the year that has just gone – and then I sat down and tried to write it! What a year!

The obvious event has been the global COVID-19 pandemic, which has had wide and deep ramifications which will be felt for generations to come.

As if that wasn’t enough – a once in a hundred year event – we also had the bushfires, followed by flooding, back to (if they ever got out of it) drought in inland regions, not to mention the lowest interest rates in over 5,000 years of economic history and the highest equity markets.

How can I fit that in to one article?

Given we are in the bond market I thought I would use the Australian government 10 year bond yield as a timeline for the year and try to highlight some of the more significant events in the bond market that gave some direction to our thinking and look at their future effects.

First some context – look at the 5-year chart below for 2- and 10-year yields:

Recap-chart-1

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Even well before we have ever heard of the words COVID-19 or coronavirus, the 10-year yield (most reflective of growth and inflation expectations) had started to decline, notably from December 2018, post the “Tech Tantrum”.

So, conditions were already primed for a significant slowdown in economic activity for at least a year before the pandemic began to emerge. Notably in Australia, the yield curve did not invert (10 year yields lower than 2 year), which it did more than once in the US market. This indicator has preceded every recession since WWII with an average 18 month or so lead time.

COVID was just the straw that broke the camel’s back, like the Lehman bankruptcy was in 2008.

Now let’s look at 2020 in more detail through the same lens:


Recap-chart-2

The first thing to note is the scale. Over the last 5 years, 2-year yields have dropped by an astonishing 2.04%, and 10-year yields, which admittedly had further to fall, by 2.68%./p>

This isn’t unusual in a recession – in the 6 months from 30 June to 31 December 2008, the 10-year yield fell by 2.45%. The RBA cash rate however fell by 4.25% from 31 March 2008 to 30 September 2009, from 7.25% to 3.00%

However, this wasn’t a recession – GDP was still growing, albeit at a slower rate, people were still immigrating in large numbers, and wages were rising, although again at a slower rate than had historically been the case.

COVID was just the icing on the cake. As with so many things, the pandemic hastened the arrival of the inevitable – such as working from home and online shopping to name just two – as years of innovation and progress were forced on us in a matter of months. The same occurred in the markets – rates fell, and equities declined – the fastest 30% decline in the S&P500 in history.

Of course, this was followed by the fastest recovery back to the previous highs which have now been surpassed once more, although not in Australia – we lagged the GFC recovery and are lagging now. The bond market not so much though, as we are still tracking along at a 10-year yield of around 0.90%, with 2-year yields at just 0.09%.

This steepness of 0.81% (the difference between the 10- and 2-year yield) is actually well above the mean and median of the last 5 years. Steepness in a yield curve is a harbinger of better times ahead, where growth and inflation are looking to pick up – so perhaps the bond market is telling us to be more enthusiastic about our prospects than most of the time in recent history.

End of March flash crash

So, what happened towards the end of March? The pandemic was just ramping up and lockdowns were coming, predictions for the economic impact were dire and usually we should see bond yields going down in these conditions – yet they spiked up from 0.60% to nearly 1.5% - in fact going from 0.91% on 16 March to 1.49% on the 19th and back to 0.91% on the 23rd.

I don’t usually like trying to come up with a story about why markets moved – reality is too complex for that, aside from some kind of announcement like an unexpected central bank rate move – but it seems to be linked to the equity markets and perhaps a strategy called risk parity.

Risk parity is where a hedge fund tries to match and offset the volatility in asset classes – usually equities and government bonds – by matching uncorrelated assets (ones that move in the opposite direction in the same conditions). For example, government bonds have a volatility of approximately 1/3 that of equities, and usually in the opposite direction. So, the hedge fund buys 3 times the number of bonds than equities and tries to match out the risk.

Recap-chart-3

Unfortunately, this requires a lot of leverage, and this is often amplified by levering the equity portfolio as well. What seems to have happened is that as equities sold off strongly, bonds had to be sold to meet margin calls, and so yields went higher on the excess supply. This made the risk balance work the wrong way and so the lenders made margin calls, forcing more selling making everything worse.

Credit spreads, as measured by the Itraxx index above also spiked as risk ballooned with the huge uncertainty meaning that investors who had liquidity available demanded higher yields for their cash – but as usually happens this also subsided quite quickly as the market made sense of what was happening and realised that these strong investment grade issuers were very unlikely (again as usual) to default and we now have spreads at or lower than pre-pandemic.

When it all settled down after a few days, we resumed normal behaviour. This highlights the dangers of leverage in even supposedly hedged portfolios.

RBA rate cuts and Yield Curve Control

In one fell swoop the RBA opened the taps and got credit flowing again.

The pandemic did cause significant distress to many businesses and claimed some casualties along the way such as Virgin Australia who suffered irreparable damage when airline travel was suspended globally.

After easing policy three times in June, July and October of 2019, as a result of below trend growth in GDP, wages and persistent low inflation, the RBA was on notice of the slowing economy and had acted.

However, the pandemic, as with so many other things, kicked the situation into another gear, and in my opinion showed how the RBA has a deep understanding of how the Australian economy feeds off the price of money and the availability of liquidity.

With the corporate bond market essentially frozen in late March and government bond markets stressed as above, both due to the unprecedented uncertainty, the RBA basically pulled out the big guns and went for broke – a key lesson from the GFC which Deputy Governor Debelle has mentioned since – there’s no such thing as going to hard too early.

Recap-chart-4

At an emergency meeting on 19 March, the RBA implemented a world first in controlling the yield of government bonds at a particular maturity – in this case 3 years – and introducing a guaranteed funding facility for the banks and also supporting the RMBS market. In in one fell swoop the RBA opened the taps and got credit flowing again.

Credit is critical to an economy – the blood in its veins or the oil in the gearbox if you like. Without it everything basically stops, as cashflows are never perfectly aligned. Working capital management via lending smooths this out and allows the machine to flow.

The RBA gave certainty of funding to banks, which in turn allowed markets to free up and transactions to happen again.

They went the next step last month, further dropping rates and announcing more traditional Quantitative Easing (QE), by outlining a state and government bond buying program to lower long term yields and also hopefully the currency.

There may well be unintended consequences, and I am in no doubt life has become very hard indeed for savers, but better that than a depression. We shall see where these actions take us over the next year.

Bond issuance

Companies with access to the capital markets – meaning large ones – have been the big winners (in a relative sense – I think few are truly winning in this situation) as they have access to capital to provide them with the liquidity to weather the storm.

In the US in particular, the moral hazard of the trillions of dollars of debt for equity swaps which has been the tidal wave of debt funded share buybacks has broken on the rocks of the pandemic. Fortunately we are more discerning lenders domestically, not so prone to lending to pay a dividend.

The chart below shows how these issuers have accessed the bond markets in huge volume to shore up their liquidity positions until we see a recovery:


Recap-chart-5

The government sector (states and federal) has clearly been a huge borrower this year – 79% of all AUD issuance - and after the lull in March when no one really had an idea about what was happening, we had a surge in April when issuers had had time to plan and come to market. We then had the next surge in September after results were available for the year to 30 June and the impact of the pandemic could be considered with some confidence:

Recap-chart-6

Conclusion

So we are now almost at the end of what has been a turbulent year to say the least. The bond market has held up really well and apart from a few days of uncertainty bonds have typically performed exactly as expected.

Government bonds have provided stability and liquidity and non-correlation to risk assets. Investment grade corporates did have some market pricing wobbles but not one is at serious risk of default.

The pandemic did cause significant distress to many businesses and claim some casualties along the way such as Virgin Australia who suffered irreparable damage when airline travel was suspended globally.

The legacy of ultra-low interest rates will have further ramifications, particularly in risk assets that are traditionally valued off these bond rates and whether they are in bubble territory – I am sure we will find out in due course.

I am happy to say that bonds did what they should across the risk spectrum, and I am confident they will continue to perform for investors in future.