Australian fixed income investors should focus on shorter-dated bonds as the US Treasury yield curve begins to steepen, says FIIG Securities.
The minutes from the most recent meeting of the US Federal Open Markets Committee suggests the Federal Reserve is likely to commence unwinding its quantitative easing programs, which will result in “a reduction in the quantity of bonds and mortgage backed securities held on the Federal Reserve’s balance sheet”, FIIG Securities said.
The firm cautioned that even if this process is well signaled by the Federal Reserve, it will likely lead to a steepening of the yield curve and a subsequent sell-off of long duration bonds.
“The Fed is a significant investor in US Treasury markets and if they do start to reduce holdings – most likely through non re-investment of coupon and principal redemptions – it is likely to lead to a steeper yield curve as demand for US Treasury bonds will necessarily fall,” FIIG Securities said.
“This is a de facto tightening of monetary policy and, in 2018 alone, would amount to an extra US$425 billion.”
Much like the ‘Taper Tantrum’ which followed former Federal Reserve chair Ben Bernanke’s signaling of an end to quantitave easing in 2013, the rise in US Treasury yields would likely carry through to Australian dollar denominated assets.
“Indeed, over the last month the AUD yield curve has rallied strongly (yields lower, prices higher), which could exacerbate the problem,” FIIG Securities said.
The firm said that while not all longer duration bonds will be negatively affected, investors must think about how they’re positioned to handle the steepening yield curve.
“Long-dated bonds with high credit margins have historically performed better in an environment where benchmark yields rise, due to those margins contracting,” FIIG Securities said.
“Holders of some longer-dated bonds … can take some comfort from this, but should nevertheless consider their interest rate exposure.”
