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Monday Insight: A 'buy everything' rally beckons for the markets

 

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Viral effect: A man wears a protective mask inside the Shanghai Stock Exchange. Photo: REUTERS/Aly Song/File Photo

Viral effect: A man wears a protective mask inside the Shanghai Stock Exchange. Photo: REUTERS/Aly Song/File Photo

REUTERS

Viral effect: A man wears a protective mask inside the Shanghai Stock Exchange. Photo: REUTERS/Aly Song/File Photo

As central banks pump trillions into the world economy, investors are setting their sights on what could be the next big thing in global monetary policy: yield curve control.

The strategy, which involves using bond purchases to pin down yields on certain maturities to a specific target, was once deemed an extreme and unusual measure, only deployed by the Bank of Japan four years ago after it became clear a two-decade deflationary spiral wasn't going away.

No longer. This year, the Reserve Bank of Australia adopted its own version. And despite officials' attempts to cool it, speculation is rife that the US Federal Reserve and Bank of England will follow later this year.

Should yield curve control go global, it would cement markets' perception of central banks as the buyers of last resort, boosting risk appetite, lowering volatility and intensifying a broader hunt for yield.

While money managers caution that such an environment could fuel reckless investment already stoked by a flood of fiscal and monetary stimulus, they nonetheless see benefits rippling across credit, equities, gold and emerging markets.

"It depends on the form and the price but broadly speaking it's the green light to carry on with the QE trade - buy everything regardless of valuation," said James Athey, who manages $3.1bn (€2.77bn) at Aberdeen Standard Investments in London.

While the Bank of England did not discuss yield curve control at its rate meeting last Thursday, some analysts think it could ultimately target five-year notes at a rate of 0.1pc, flattening the yields out until that maturity.

Demand for shorter maturities could drive up rates on longer peers - a mixed blessing for pension funds and life insurers, which could see their existing holdings devalued, but be able to buy new assets for less.

Federal Reserve chair Jerome Powell said the usefulness of the policy "remains an open question" on June 10.

While most expect a low-yield target for shorter maturities, potentially as soon as September, it could focus further out on the curve.

Five- and seven-year Treasuries may rally if the Fed looks to go beyond controlling just the front end.

Where central banks set their target will be key and could send assets swinging either way.

A 50-basis-point target on the 10-year Treasury yield would spark a bond rally and flatten the curve alongside a probable rise in equities.

However, a full percentage point could see bonds bear steepen and trigger a sell-off in shares, said Aberdeen Standard's Athey.

Capping interest rates would help by ensuring corporate borrowers continue to benefit from attractive financing rates.

Lower yields in longer maturities would assist investment-grade companies, which tend to issue longer-dated debt than lower-rated borrowers.

Meanwhile, junk borrowers would reap the rewards of the general boost to market sentiment.

Companies with high debt loads such as airlines and energy could get a lift, said Charles Diebel, who manages $2.6bn (€2.3bn) at Mediolanum in Dublin. UK banks could also gain as lenders will have escaped the crushing effect of negative interest rates.

"It will allow the whole rating spectrum of fixed income credits to borrow at incredibly cheap absolute levels during a time of much uncertainty and would certainly be very bullish," said Azhar Hussain, head of global credit at Royal London Asset Management.

Lower rates in the US could weaken the dollar and help riskier currencies like the South African rand and Mexican peso.

Carry trades involving the Indonesian rupee and the Russian rouble could also benefit, as well as Group-of-10 currencies like the Australian dollar and Norwegian krone, according to Vasileios Gkionakis, head of foreign-exchange strategy at Banque Lombard Odier in Geneva.

The move could also send dollars flowing into carry trades targeting US assets.

These could include mortgage-backed securities, as well as sovereign, supranational and agency bonds.

Of course, such a widespread bullish outlook comes with risks, especially at a time when asset valuations are near extremes. A rally in US stocks has pushed estimated price-to-earnings to the highest in almost two decades.

Meanwhile, 10-year yields are negative for nine of 25 developed markets tracked by Bloomberg and the rest are well below their one-year averages.

It's a precarious bubble that could eventually burst, should the wall stimulus spur inflation down the road and eat into investors' profits.

Regardless, the notion that central banks are approaching some sort of curve control is here to stay.

Japan has tethered its yields, although in Australia, yields on longer date bonds are some 30 basis points higher than they were in February.

A key lesson from 2008 was that policy makers need to intervene quickly, and investors now expect them to consider any weapon at their disposal.

"Policy makers tightened up the banking system so much the markets became too big to fail," said Mark Nash, the head of fixed income at Merian Global Investors in London.

"Now they have no choice but to keep them working."

Bloomberg

Bloomberg