SQM Research Newsletter and Ratings Update - November 2021

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by Rob da Silva, Head of Research

The bond apocalypse may be upon us. The drums of inflation have been beating louder and louder over recent months, with a crescendo reached recently as the latest US CPI print showed 6.2% yoy inflation. Well above expectations and fueling concerns that the surge in inflation may not be as temporary as many thought (or hoped).
Central bank rhetoric has shifted in response, moving away from infinite stimulus and towards easing up on the accelerator or tapping gently on the brakes. The markets appear unsatisfied with this pace. William McChesney Martin Jr. (the ninth Chairman of the US Federal Reserve) famously said the job of the Federal Reserve is "to take away the punch bowl just as the party gets going.” Over the last couple of months the market has decided to grab the punch bowl from the slow moving Fed/RBA and throw it out the window.
The RBA has removed yield curve control (somewhat clumsily) and market reaction was swift.
The effects were felt right along the yield curve.
The money markets are taking a much more pessimistic stance than the RBA on the path of interest rates. While the RBA remains reluctant to signal material tightening anytime soon, the chart below shows the futures market expects a cash rate of 1.40% by April 2023.
There are echoes of this market action in the US as well. The 2 year yield has taken off….
…and the 10 year Treasury yield has moved higher as well, although not breaching recent highs.
The probability of the Fed Funds rate staying the same through to June next year has plummeted.
While the probability of 2-3 rate hikes in six months has surged.
So long duration has not been the place to be, particularly recently, but actually also for the entire last 12 months as the graph below shows.
This chart plots the growth of $100 for a group of the largest high yield funds versus a group of the largest Australian duration (i.e. benchmark aware) funds. The gap is more than 11% difference in performance over 1 year. That is seriously unpleasant for bond investors.
The chart below shows this trend has been strong through the year – with a pause for breath between Feb and Aug.
So what to do? The market is pricing in a fair degree of pessimism so it might be argued that the storm is past. However, it is also possible that there is more to come. The key is inflation. Watch those trends. Supply chain issues, product shortages, “the great resignation” leading to labour shortages, wage gains, consumer expectations for higher inflation. If the surge proves to be temporary, then the markets will settle down. If inflation looks to be taking a stronger and more permanent grip on the economy, then volatility and tough times are likely ahead for the bond markets

Markets have been all about risk assets – duration is dead last! But risk assets might join the “misery loves company” crowd if the inflation dragon is unleashed.
Next month’s newsletter will have a simple tour of US and Australian inflation in pictures.
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