Time to go global as the US Federal Reserve can cut rates after weak US employment data

Charles Jamieson

Charles Jamieson

Global trade data has been slowing rapidly over 2019, but last week’s US employment report was a dire warning, and can expedite the US Federal Reserve (the Fed) towards rate cuts later this year.

US employment was weaker at a headline level, with revisions and average hourly earnings also slipping backwards, a trifecta of slowing US employment data. Trade wars and slowing global growth will likely see this continue.

Is the Fed right at the start of its rate cutting journey?

It has 250 basis points, or 10 rate cuts of 25 basis points to possibly move to a zero cash rate, plus additional Quantitative Easing (QE) if required. Compare that to AUD interest rates, where we think we have received 1 of 4 possible cuts towards a 0.50% RBA cash rate (we would expect the RBA to do its own QE once a 0.50% RBA cash rate was achieved).  US Government bonds will have a powerful tail wind blowing firmly at their back should the Fed cut interest rates, as many commentators are now suggesting. Such moves could provide strong winds of performance and return for investors in defensive strategies with strong exposures to US Government bonds.

As we’ve all now experienced from AUD interest rates over the last six months, the major challenge for investors remains how to view this allocation in a ’forward’ context.   Investors who did not pull the trigger in AUD rates should be highly motivated now, given the powerful portfolio performance they have missed. A few people have now admitted that cash has burnt a solid hole in their own portfolio attributions, particularly in the fourth quarter of last year. With the Fed possibly at the start of their own rate cutting journey, the gift of a second chance may have arrived for defensive asset holders.

Is this likely an ’insurance’ cutting cycle or something bigger?

In 1987, ‘95 and ‘97 the  Fed cut interest rates by 75-100 basis points to be ‘ahead of the curve’. This stimulus worked, and the US economy and investment cycle was saved by the Fed providing some cycle ‘’insurance’’ to the market. In this instance you bought bonds, but didn’t need them to save the day for portfolios as most assets valuations held up thanks to the Fed that stayed ‘ahead of the curve’. The returns from bonds were strong during these times. Any rate cuts are usually good for Government Bonds.

But if the Fed falls ’behind the curve’ it has  to cut rates much deeper. Rate cutting cycles of 1985, 1989, 2000 and 2007 required 300-500 basis points of cuts. Today we would have a problem delivering this as the Fed only has 250 basis points as a starting point.  If the Fed is ‘behind the curve’ there is a chance it will use the lot plus more in QE.  This is when bonds will likely deliver exceptional returns, performing whilst other assets might be challenged, depending on the reason for cuts (especially if credit problems arrive). The GFC was a classic example of this.

We think these investment themes are powerful and any allocation arguments are highly compelling.  The last Fed cutting cycle started more than 12 years ago.  It could be years and years until investors get this type of set up again.

A ‘flight to quality’ at a time of uncertainty

Monetary policy and other macroeconomic fundamentals remain the key drivers of bond market performance and can vary between countries, meaning returns can also differ. Diversification across countries can help to reduce overall portfolio risk. In addition, a global bond allocation can deliver Australian investors returns from multiple sources:

  • Bond coupon or income – highly likely, as long as governments stay solvent.
  • Foreign Exchange (FX) forward hedging benefit – highly likely if AUD rates are higher than some peers (currently EUR and JPY).
  • Bond capital gains – compelling and likely if the Fed cuts rates.
  • Alpha generation – good managers should be able to generate alpha (additional return beyond the index) over time.
  • AUD FX depreciation (only in an unhedged class allocation) – this is harder to predict, but a huge possible return driver as seen in the GFC.

A strong tail hedge solution for Australian portfolios

In our own global bond fund strategy, we consider these five levers when actively managing the portfolio.  AUD FX is the hardest to predict. In serious times of crisis, the AUD has historically depreciated more often, than not. During the GFC this was hugely material, with the AUD depreciating from 0.9850 on 15 July 2008, to just 0.6009 on 27 October 2008, providing substantial returns for holders of global bonds on an unhedged basis. The period during the GFC produced a top to bottom move in $AUD versus $USD of +63.92%. Added to the powerful performance of bond markets in that period made a global bond allocation an amazing negative correlator/buffer to the equities losses that were suffered in 2008.

By Charlie Jamieson, CIO

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