Thursday 11 February 2016 by Opinion

Why is the AUD so high, when markets are slowing?

The main economic themes haven’t changed much in the past 18 months. What is new is that markets are starting to price in a slower global economy for longer. We suggest some strategies and specific bonds that may help position your portfolio

three snails

Global economy notes:

  • Price earnings ratios for equities are still high by historic standards and likely to keep falling throughout 2016
  • Market rates for commodities have dramatically corrected to reflect a slower economy, and if anything, are now too cheap
  • Whether oil recovers in the second half depends upon the supply injected into the market by Iran and Iraq this year, and how long some of the more financially fragile producers like Venezuela or smaller US producers can hold out. Our forecast is that oil will stay between $25 and $40 throughout 2016, and will remain extremely volatile as market traders try to guess the next supply side response
  • Industrial metals aren’t subject to the same level of trading, but will remain depressed as long as fears about a China hard landing remain, which could be as long as a few years, not just months

Opportunities prevail

Bond markets, our area of expertise, are pricing in slower for longer now, but not consistently. Throughout 2015, we told clients we thought that the US 10 year benchmark rate (10 year Treasuries) was good value at anything above 2.00% p.a. and the higher the better obviously. At times during 2015, this benchmark traded at over 2.30% p.a. It is now 1.75% p.a., 65bps lower. To put that in context, imagine if you had the chance to put money into term deposits at 0.65% p.a. higher than the current rates and lock that in for 10 years. That is the sort of opportunity that these rare periods of very high volatility present.

Bond markets haven’t been consistent in repricing. There are pockets that are still slow to reflect the new global reality of a much slower decade or more in front of us. Australian long term corporate bonds are a good example. A slower world economy, particularly if a China slowdown is the primary cause of this as we believe, should mean lower growth for Australia and therefore lower interest rates. Inflation is the only reason that this wouldn’t be the case. But Australian interest rates remain significantly higher than US rates, which doesn’t match the fundamental reality.

AUD artificially inflated

This has in turn meant that the AUD is artificially inflated. Why? When greed turns to fear, investors shift from equities to bonds. This oversimplified but accurate pattern gives us a clue to what they are looking for - safety, while keeping a reasonable return. This adds to the activity in what has become known as the “carry trade” – borrowing in a cheap low rate currency to invest in a low risk higher rate currency (for example borrow in Yen to invest in AUD). When it comes to government bonds, the largest bond market, there are only five of the world’s largest economies’ government bonds that pay more than the US: Greece, Spain, Portugal, New Zealand and Australia. The first three are hard to call 'safe', so the global choices are narrowed to Australia and New Zealand. 

With two choices and with not a lot of bonds on issue from those two countries, a small amount of demand from the world makes a big difference to the prices of our bonds. It also makes a big difference to our currency. We are simply too small an economy to manage our currency when it comes to large flows. We saw that post-GFC when the RBA simply couldn’t control the rise of the AUD and it similarly cannot control the decline or the volatility at times like this.

So the short answer to the question of why the AUD is up when world growth is being downgraded is simply short term flows of capital seeking a safe harbour and yield. As the yield differential between the AUD and USD bonds falls, which it will as the world’s growth expectations fall, the demand for Australian assets either as a higher yield safe harbour or for the riskier carry trade, will fall. And then we will see the new equilibrium level for the AUD against the USD, GBP, JPY and EUR in particular. Our expectation is that that level against the USD will be around 65 cents, with more risk to the downside than the upside linked to the fact that China has more downside risk than upside risk.

Strategies to consider:

  • Buy longer dated AUD bonds, particularly higher quality like infrastructure bonds
  • Buy USD denominated corporate bonds at levels above 70 cents in particular, either high quality or if in the high yield sector, well diversified and avoiding the oil sector

A few suggestions:

AUD long dated bonds

Company Maturity date Bond type Capital structure Yield to maturity  Income  Minimum face value parcel 
Sydney Airport Finance 20/11/2030 Capital indexed Senior debt  6.00% 3.26% $10,000
Asciano Finance Ltd 19/05/2025 Fixed Senior debt 4.90% 5.10% $10,000
Rabobank Netherlands AU 11/04/2024 Fixed Senior debt 3.40% 4.79% $10,000
Queensland Treasury Corporation 14/03/2033  Fixed  Senior debt 3.20% 4.56% $10,000
SCT Logistics  24/06/2021  Fixed  Senior debt 7.15% 7.49% $10,000

*Rates are indicative only, accurate as at 11 February 2016 but subject to change. Bonds in red are available to wholesale investors only.

USD long dated fixed rate

Company Rating Maturity/call date Capital structure Yield to call/maturity Income  Minimum face value parcel 
Newcrest Finance BBB- 01/10/2022 Senior debt  6.30% 4.72% $10,000
BHP Billiton Finance USD Ltd BBB+ 19/10/2025 Lower Tier 2 7.10% 6.94% $200,000
Virgin Australia B- 15/11/2019 Senior debt 8.00% 8.39% $10,000
QBE Capital Funding III Ltd BBB 24/05/2021 Lower Tier 2 4.90% 6.54% $200,000

*Rates are indicative only, accurate as at 11 February 2016 but subject to change. All bonds in the list are fixed rate and available to wholesale investors only. 

Note: If you are interested in learning more, please register for Craig’s upcoming webinar based on The 2016 Smart Income ReportExternal link - opens in a new window.