Bernanke throws the cat amongst the pigeons

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Following Chairman Bernanke’s comments that the Fed would be reviewing the Quantitative Easing (QE) program, with the view of easing the US$85 billion per month bond buying program later this year (with the program removed in 2014 depending on economic data), global markets sold off dramatically, as investors switched out of equities, government bonds and ‘risk assets’ including the AUD.

The sell off reflects the market’s re-assessment of the view of ‘free money forever’, where taking risk (buying risky assets) was essentially underwritten by the Fed’s continued stimulus of the economy. Without the stimulus, investors began to actually look at risk, and the price they were paying, and didn’t like what they saw. Prices (and risk) were essentially being underwritten by the external stimulus provided by the Fed, not by fundamental economic growth.

Large movements were also seen in currency and bond markets, the latter impacted by the realisation that a very large buyer of bonds (the Fed) will no longer be there when QE is removed, hence reducing buying demand.

The market reaction was a fall in government bond prices and an increase in yields (given the inverse relationship between fixed rate government bonds and yields). This in turn impacted swap markets.

The graph below shows the movement in the 5-year AUD swap curve over the last few weeks. It is not hard to guess which day Bernanke made his comments.

The 5-year swap curve (effectively the rate the banks will lend amongst themselves) jumped from 3.3550% on the 19th of June, to 3.9188% on the 24th – a move of 56 basis points. Whilst this (the 5-year curve) represents a specific point, this widening was repeated throughout the swap and government curves, resulting in a dramatic steepening.

The curve has come back since, but still remains wide of where it was prior to the Bernanke announcement.

Short cash/long bonds

If we look at the change in the 5-year swap curve from 12 months ago to today, we can see the dramatic effects of recent market movements, and this presents a trading idea for investors.

In the graph below we can see the pale blue line is roughly a shallow ‘U’ shape. What this shows is that 12 months ago there was tremendous value on offer in the short dated market, which for most investors is the term deposit market. In fact, the curve was offering better returns for 30 days than it was for three years. At this point it made sense to invest in term deposits, with their government guarantee, and take the strong rates on offer.

Fast forward 12 months, and the curve has changed dramatically. No longer a ‘U’ shape, the curve (the dark blue line), has moved into a more traditional upward slope. This upward slope has been further exaggerated by the moves over the last two weeks. As you can see, the short dated (term deposit) money is no longer offering the great returns which were around last year, however the dramatic steepening of the curve from one year out is offering returns for investors prepared to invest in longer maturities.

So what is this telling investors? For those still sitting on cash and seeking higher returns, it is an opportunity to move further up the curve and take on some longer dated exposures, potentially around the five year mark.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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