There is a clear breakdown in the multi-year yield trade; a ‘what happens next’ event brewing in the US as we approach the end of October (the end of the asset purchase programme and the rising of rates); and volatility is strengthening.
This is why future strategies in the current market need to be measured as current conditions are likely to produce short and sharp movement of volatility. Navigating the current landscape requires some patience and understanding.
Fundamental analysts have been calling for the end to the ‘priced to perfection’ yield trade for 18 months. The rise in the likes of CBA and Westpac has well and truly overshot fundamentals, with P/E and margin squeezes being completely overlooked for the returns on offer from the expanding payout ratios and dividends.
I have been very aware of how the low cash rate environment has positively impacted the bidding up of the yield trade in Australia. The cash rate has remained unchanged for 14 months and is unlikely to shift in either direction before the end of the year. In a textbook situation, this would continue to champion the call for the yield trade; however that view is too myopic as the ASX is part of the global market.
Interest expectations in the US have changed; investors are speculating heavily that the Fed is gearing up to use mechanisms to raise the Fed funds rate. This speculation has led to selling in the bond markets and has driven up bond yields across the globe.
Australian ten-year bonds have increased by over 45 basis points in the last month; the US ten-year yields have also shifted higher on expectations of rising rates. This, coupled with the end of the asset purchase program, has finally sparked the rally in the USD that everyone has been forecasting, which has seen the AUD lose over 6.5 cents in last than a month.
This has almost perfectly translated into the collapse in the banking index, which has lost over 9.3% since September 3 and has technically corrected since its peak in July. This means that since the peak the banks have lost double their prospective dividend yield in real capital terms. For US investors however, they have experienced triple the capital loss once you convert the fall in the banks into USDs, while Japanese investors have lost 2.6 times the prospective dividend yield.
This trade is unwinding fast; Japan is one of the largest investors in yield and has allocated a huge sum of funds to the Australian yield trade over the past three years. Although its currency has plunged against the USD, paired to the AUD it is actually rising as Japanese investors have been squeezed by the falling currency and falling returns.
The end of the carry trade
This move in the banks has led to the sharpest rally in volatility since January and it is only going to increase over the coming six months. Increasing volatility has the largest effect on the carry trade because it will finish it.
The carry trade only works in low volatility: rising markets with stable currencies. All of these factors are breaking down as the currency and market volatility are only going to move higher and equities are going to move lower.
The breakdown in the carry trade is likely to squeeze the yield trade even further, which could also affect equities such as Telstra, the utilities and REIT spaces. This is a call that is hard to make, as it has been so well loved over the past three years and most retail investors are fully invested in these sectors, but the end does appear to be near.
This culminates in the biggest issue facing the ASX as an index: the banks alone make up 23% of the market and Telstra and the supermarket providers make 37% of the index. This is why the ASX will continue to suffer as the yield trade is shaken out. I remain tactically short the space until I can see clear signs of support. I am also cautious of the yield trade as any further signs of rising Fed funds rates will spook the trade further.
My strategy for the US has remained unchanged as the trend has yet to be broken; however if and when the future market experiences a 5% or more pull-back (which is very possible with the events that are approaching), then this will only add to the pressure seen in the ASX.
I see cheap growth stocks as the eventual winners on the ASX, however this trade is possibly not one to enter yet as all players in the market could see downward stress over the coming 31 days as the US approaches the end of the asset purchase programme.