Originally published by The Commonwealth Bank of Australia
Great Rates Expectations: in the face of war. Keep calm and stay long.
| ■ | We update our thoughts on policy, and continue to challenge market positioning. The Fed will normalise policy, if inflation lifts, at an ever so gradual pace. The Antipodean central banks are sidelined, in our opinion. We extend OIS trades. |
| ■ | We also discuss the risks of war, with North Korea, from a market’s perspective. Our trade recommendations are designed to capture normality in the north‑west, dance with neutrality down under, and guard against war in the East. |
Our core strategy remains intact, but our trades have been frustrated with mixed performance. We remain long Antipodean bonds relative to US Treasuries. And we continue to look for steeper curves. Both positions are taking longer to bear fruit. In the Antipodeans, both the RBA and RBNZ are firmly sidelined until 2019. So we extend our received positions out the Antipodean OIS strips. In the US, we also creep out the OIS strip, to pay a market under‑pricing Fed normalisation. Our US trades have been frustrated by soft inflation prints. Talk of debt ceilings and war with North Korea have also hampered paid positions. But for all the talk of war, the market does not believe. We have seen some volatility, yes. But despite the passionate headlines, markets have yet to react in a meaningful way.
Nervous posturing with North Korea escalated last week. Trump’s “fire and fury” line struck a nerve. Volatility spiked, and the vol‑of‑vol shot for the stars. Headlines suggested (nuclear) war was imminent. And Australian PM Turnbull said “Australia will come to the aid of the United States… The United States has no stronger ally than Australia.” War is hard to contemplate and emotional. From a clinical “markets” perspective, there are trades that work, time and again, in the face of war. In the lead up to World War II, the Australian government inserted capital controls as an “unmistakable” and “unwarranted” amount of Australian dollars headed for US dollars (not pounds). Australians converted cash into gold. We haven’t changed in our fears or desires. And in the face of war there are three trades that work, historically.
1. Buy gold, and silver. In the face of extreme events, regime changes, or rampant inflation, fiat money is dumped for something known to last the test of time: gold. For now, gold is at the top of a low range.
2. Buy the victor’s currency and bonds. The US dollar is the global reserve currency, for a reason. The US has the largest economy, and military. US bonds will outperform, as safe haven flows convert into Treasuries. Other currencies of benefit are Swiss francs, and Japanese yen. The fact the US dollar hasn’t responded, tells us the market is sanguine.
3. Sell Antipodean currencies, even as their bonds rally. Antipodean currencies come under pressure, as global growth expectations shatter. Small open economies are not the place to be. (Unless you’ve purchased your ‘end of the world’ hideout in New Zealand). A troubled Asian outlook (North Korea) would be particularly acute, as China is now the Antipodeans’ largest trading partner. Offering some comfort for investors, however, is the fact Antipodean bond markets would outperform markedly. Thoughts of rate hikes would quickly turn sour, and into delivery of sharp cuts. Received OIS positions would work.
We raise these ‘trades’ for one reason, keep calm and stay long. When we look at the price of gold, US dollars, the Korean won, and the Antipodean currencies, thoughts of war have not (yet) translated into panic of any kind. But the risk of war has risen, albeit modestly, so a hedge or two may be prudent while they are still cheap.
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