Wednesday, 18 October 2017

On yields and currency risk

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  • Anthony Peters

Anthony Peters goes back to basics for bond traders.

A year ago, give or take, UK 10 year Gilts were trading within 37bp of German Bunds and well through French OATs which were about 80bp back of Bunds. At the time, trading close to Bunds was regarded as a badge of honour. Since then, the relationship has very much reversed with OATs at 45bp and Gilts 94bp. The question is, does one want to trade close to Bunds or not?

The answer is pretty simple: if you’re a member of the eurozone, then yes, if you’re not, then no. The rise in the yield of Gilts is not, as not so long ago would have been declared, a function of declining credit quality but of a recovering economy. How the world changes! Perhaps the lesson should be that not too much should be read into relative yield levels and maybe even less into absolute ones.

Let’s face it, the currency choice is the first and most important decision which an investor has to take within an allocated asset class.

Foreign exchange markets understand that the most basic element in comparing two or more markets is to be found in the currency rates, adjusted to account for the underlying volatility. Bond markets, though often regarded as reasonably sophisticated in their analytical ability, seem to struggle when it comes to taking into consideration the currency factor.

This becomes most evident when young and enthusiastic corporate bond traders whip up their sales people to suggest that clients sell a bond of a particular issuer in one currency to buy a bond of the same issuer in another currency for a given pick-up over the relevant swap curves. Now, I’m not quite sure what world these guys live in but in over 30 years in this business, I’ve never seen an investor do that trade. I’ve seen people appreciate that a bond in one currency is cheap on a comparative basis to a similar bond in another currency but I’ve never seen anyone actually do the switch.

Let’s face it, the currency choice is the first and most important decision which an investor has to take within an allocated asset class. The decision on duration comes next and the choice of individual security comes at the end. I digress.

To proffer trade ideas without actually including either the cross currency risk or the hedge cost in the calculation demonstrates, to some extent, the low level of interest the Street seems to take in and understanding it has of its clients’ business. In the same way, to some extent, spreading Bunds against Gilts and Treasuries or JGBs without an accompanying total return analysis including the corresponding strip of currency forwards is something of a mug’s game if one is aiming to appeal to anyone other than the more basic end of the leveraged account community.

Acceleration in Albion

UK economic releases are becoming progressively more supportive of the glass half full and filling community. Yesterday’s October PMIs, though a mixed bag in terms actuals versus forecasts, are clearly supportive of growth picking up momentum. The Manufacturing PMI read 56.0 (56.4 expected) and the Construction PMI came in at 59.4 (58.7).

Although I still remain extremely wary of an economy which is purportedly growing while real wages are still falling and while the trade balance isn’t really improving, I must concede that the “mood” is improving and that therefore a widening of spreads between Bunds and Gilts is, theoretically at least, something to be celebrated.

Experience which should be drawn pretty much since the beginning of the last decade is that absolute levels of rates are a parochial issue and that playing the comparative rates game might be fun for analysts, chartists and statisticians but that it truly adds no value to anybody else. For proof of that, go to Hungary and look what happened when half the country took out low interest mortgages in Swiss Francs. This has been a drag on the economy for at least ten years and the government has now intervened to find a way of helping those households which have been slaughtered by not knowing how to account for currency risk.

Maybe the time has come for British Chancellor of the Exchequer, George Osborne, to stand up in parliament and to crow at his opposite number, Ed Balls, that two years ago it was an honour to have rates close to Bunds but that now it an even greater one not to have. That Sterling is “only” 5% weaker than the euro over the period is, in my book, neither here nor there. 

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