Ying Yi Ann Cheng, Portfolio Manager of the Switzer Higher Yield Fund appeared on Switzer TV to provide an update on what’s going on with interest rates, the consternation in the US, and whether that could lead to rising interest rates.
Peter Switzer (PS): Joining us now is Ying Yi Ann Cheng from Coolabah Capital. Thanks for joining us, Ying Yi.
Ying Yi Ann Cheng (YYAC): Thanks, Peter.
PS: We always sort of use you as our why to understanding what’s going on with interest rates. And there’s a little bit of consternation in the US, and whether that could lead to the Americans rising interest rates. What’s the house view on US inflation and its possible impacts on interest rates?
YYAC: We’ve spoken about this before, and to be honest, the Fed has said that they will go ahead with tapering at some point this year. You know, very much the view that we have is yes, they should go ahead with that, notwithstanding the concerns around Delta. Whether it’s RBA, as I said, or the Fed in the US, has to navigate around what is happening in the near term with the concerns around Delta. But also, navigate monetary policy, which is much more forward looking as a result.
So, they have to not only do they have to nowcast, but they also have to look into the future to a certain extent when they dictate monetary policy. The first step for them would be to take our bond purchases as a first step to target any sort of inflation concerns. Now, inflation is still manageable. So, up until they get to the point where inflation does sort of crate towards the higher of the 2 to 3% bad, they are unlikely to hike interest rates. So, first they need to reduce their bond purchases. Then at a future point in time, they will start hiking sort of rates. At which point then, yes, any sort of portfolio that has interest rate risk, so long end bonds, or what we call interest rate duration risk, or fixed rate risk, is obviously something that will be exposed to that more on the downside.
PS: If the yanks say moved like 2022, because it’s growing stronger than people expected, inflation is higher than they expected, do you think that would put pressure on our Central Bank to raise interest rates, or would Dr. Lo stick with his 2024 promise?
YYAC: It’s really interesting. There’s obviously a lot of crosswind in that sort of thinking because on the one hand, currently Australia’s borders are closed, right? Which means that without the non-residents in Australia, that’s put inflationary pressure on wage inflation here. And it’s also meant that unemployment’s gone down as well because the supply of labour is less. Now, come next year when we are probably expected to re-open our borders, then you would expect that non-resident, or that supply of labour, to come back into the country. Which has the effect of deflationary effect on wages. Which is probably the most important thing. The most important thing feeding into what the RBA is looking at in terms of inflation, is very much that wage inflation number.
When these non-residents do return because of open borders, that will have a deflationary aspect. On the one hand, yes, you could say that because the Federal Reserve is starting to hike rates, that will potentially give as some sort of a green light for other central banks to not deviate too much from that sort of policy. But the RBA needs to watch what’s happening domestically, which is likely to be deflationary, if anything. For us, inflation is less of a concern in the next couple of years. It might be something come 2024, which is more realistic. To answer your question, we think the RBA will more likely sort of stick with the, the current sort of program and look at what’s happening domestically.
PS: Now, your boss, Chris Joye, writing in the AFR was talking about how, because the States are spending a lot of money and state government bonds are really popular and they’re issuing more. You guys manage the Switzer Higher Yield Fund, which is basically a bond fund and primarily government type bonds, or really a blue-chip type banking type bond. What’s it going to do for the fund? Is it a good thing or a bad thing for the fund that state government bonds will be in more supply?
YYAC: Well, more state government bonds supply has actually meant more bonds, and that actually has reduced prices. How they’re going forward. The expectation is that the supply will be met with very substantial demand. So, let’s just talk about the supply picture first, and then I’ll address the demand, sort of dynamics.
As you guys know, and as your audience would know, the prices are determined by demand and supply. So, the more demand, the higher the prices. The most supply, the lower the prices. On the supply side of the equation, basically state government bond prices have cheapened up, so we see very significant value. We think that they’re the cheapest asset class around, compared to equities, compared to corporate bonds for example. We think they’re the cheapest asset around simply because the state governments have recently, despite the fact that they’ve all announced a smaller than expected budget deficits, recently New South Wales was the outlier.
So, New South Wales announced a smaller than expected budget deficit, which means that you would expect that they would need to issue less bonds, or less debt, as a result. What instead happened, was that they announced a much larger insurance program for the coming financial year. So, this was known as a New South Wales funding shock, and that funding shock caused state government bond prices to cheapen up quite aggressively. The yield goes up, and the bond prices moves lower as a result. Then another added pressure has been obviously the lockdown.
So, the Delta induced lockdowns in New South Wales and Victoria had the market speculating that New South Wales and Victoria would need to issue more debt, and therefore bond prices move lower again. That’s essentially because lockdowns cost money, right? And the states hadn’t budgeted for that, say in May and June when they announced as well. However, what we’re finding is that, potentially that there’s going to be much less debt issuance than the market expects. So, less debt issuance, mean bond prices move higher as a result.
Why do we expect to less debt insurance? Well, firstly, we think that New South Wales will go back to clearing some of the debt that they announced. At the same time, and that comes from the sale of West Connects. So, they already have $15 billion from the first half of the West Connects sale. They’re likely to receive the second half of the funds this month as well. Our expectation is that they will use that money to reduce debt. Secondly, at the same time, if you look at what New South Wales is actually spending on the lockdowns, it’s actually around 50% of what they actually budgeted. So, this lockdown is actually not costing them as much as they had budgeted. Thirdly, we’re expecting New South Wales to come out of lockdown in October. So, the New South Wales government is quite married to that 70% to 80% vaccination rate, as opposed to the daily case numbers. This will be positive for the economy, but also for the bottom line for the New South Wales government as well.
So, that’s on the supply side, we’re expecting less debt issuance. The demand side is incredibly interesting. As I mentioned, the more demand for state government bonds drives the prices higher. The demand side of the equation is very much driven by what our thinking around this facility, called the Committed Liquidity Facility. Now, I don’t want to get too technical, because you do pull me off about being technical too very often. But essentially, if you think about it, globally, regulators require banks hold emergency liquidity. And what is the best form of emergency liquidity? Government bonds. Now, post GFC our government bond market at the time, if you rewind, wasn’t very big. We didn’t have a very large government bond market. If the banks needed to hold these government bonds as emergency liquidity, the RBA and APRO were concerned that the banks would crowd out the government bond market. It meant that other people couldn’t buy government bonds, and you don’t want that. Instead, the RBA, the Deputy Governor introduced the Committed Liquidity Facility, which is known as the CLF. Within this Committed Liquidity Facility, the banks were able to hold alternative liquid assets, as a surrogate. What sort of alternative liquid assets? Well, it included their internal home loans – It included RMBS, each other’s banks’ senior bonds. Frankly, if you were a bank, and you were focused on maximizing return on equity, holding those sorts of securities, or holding those assets generate much higher ROE’s than you would on say, investing in government bonds.
Now, the thing is, APRO has been telling the banks, for quite some time, that the CLF needs to disappear. Because we don’t have the same situation that we did, say circa, ten years ago. Instead, the government bond market has grown significantly, because governments have had to raise debt to address issues around COVID. So, the size of the government bond market is actually one half trillion dollars now. The banks don’t really have that same excuse to hold alternative liquid assets, as emergency liquidity. And so, the expectation from many in the market, was that the CLF would disappear over two or three years. Our thinking has been that there’s cause for APRO to reduce this in a shorter timeframe, and ACRA announced this on Friday. They said that the CLF needs to disappear by the end of 2022. The size of the CLF is $140 billion or so, which means that that $140 billion needs to find its way into high quality liquid assets. What is a high-quality liquid asset? It can include deposits with the RBA. That earns 0%, or it can go into Commonwealth government bonds or state government bonds. Now, if you work from an economic point of view and the delays that the banks are focused on maximizing return on equity, then they should target the highest yielding of those options, which would include those set government bonds.
PS: State Government Bond, yeah.
YYAC: Yeah, we’re constructive on multiple fronts there.
PS: So, the bottom line is, is this a good thing for the Switzer Higher Yield Fund?
YYAC: It is.
PS: Okay. That’s all I care about. Alright. Ying Yi, thanks for coming on the program.
YYAC: Thank you so much, Peter.
DISCLAIMER: Past performance is not a predictor of future returns. This update has been prepared for information purposes only. Any figures provided in this document are unaudited and approximate. This post does not contain investment recommendations nor provide investment advice.
You are strongly encouraged to obtain detailed professional advice and to read any relevant offer document in full before making any investment decision. This is not an offer to invest in any security or financial product.
© 2021 Contango Asset Management Limited.