Wealthy Nations Daily Update - Yellen and Relative Value

After a couple weeks of hawkish comments from Fed members, Fed Chair Yellen stepped out for the first time since the last FOMC meeting mid-month and remained true to herself; maintaining her dovish credentials. A cautious approach in adjusting policy was the theme of her speech which she delivered at the Economic Club of New York yesterday. She highlighted that a cautious stance is “warranted because, with the federal funds rate so low, the FOMC's ability to use conventional monetary policy to respond to economic disturbances is asymmetric”. Like us, she noted that domestic inflation is “somewhat more uncertain” adding that although there have been signs of pick-up, US economic indicators remain “somewhat mixed”. With increasing global uncertainty, Yellen even discussed the central bank’s “considerable scope” to ease if the economy falters, “we used them effectively to strengthen the recovery from the Great Recession” and would do so again, adding that “only a modest degree of additional stimulus” can be provided.

Yellen achieved what she set out to do, the dollar (DXY Index) fell 0.82% yesterday and has continued its slide today; ~0.2%, at time of writing. US Treasury yields were also pushed lower, with the 10-year falling to fresh multi-week lows, while the 2-year, which had risen as high as ~1% earlier this month, fell to 0.79% yesterday, and has traded lower today. The futures market sliced expectations for a rate hike in June by 10%, from 38% ahead of the meeting; one thing of note is the three employment readings remaining ahead of the mid-June decision, so it is anyone’s guess. The ADP employment reading for March, which gives a hint of the all important non-farm payroll, was released above market expectations, at +200k; indicating once again that the labour market remains stable. The team at Stratton Street believe that the Fed will struggle to raise rates in June as global factors continue to drag, and we maintain our expectations that the Fed Funds rate will remain below 1% this year. We also remain very comfortable with the portfolio’s diversified construction.

Through our portfolio selection process, we use our proprietary Relative Value Model (RVM) to assess the relative “cheapness” of a bond, before we analyse the credit itself, to decide whether the issue offers both an attractive expected return and holds enough “credit cushion” for us to add to our portfolio. The RVM aggregates all spreads available for any credit rating of a given maturity or duration available in today’s market and then compares individual issues against the average of all similar credits of the equivalent rating and duration. Through this process our model highlights anomalies within our investment grade bond universe (which currently consists of over 9,000 bonds); which the market has in effect priced incorrectly.

To show how this works, we have created a chart, on our website under The Weekly tab (http://www.strattonstreet.com/the-weekly/) which clearly shows just how much some bonds can be mis-priced. An example could be our quasi-sovereign holding in sterling issue Russian Railways (RZD) 7.487% 2031; 100% state-owned monopoly owner and operator of Russia’s rail infrastructure and services. Having rallied over 13 points since mid-January, the bond currently trades at a spread of 560bps over Gilts, yields 7.5% and has a 2.5 credit notch cushion; remaining very attractive on a risk-adjusted basis. As you can see from the BBB chart, on average, similarly rated bonds (Baa3) with a duration of ~9 years, trade at roughly 330 bps. This suggests that this bond would need to tighten a further 230 bps to reach “fair value”, or gain around 24 points to match its peers.

If you would like more information on the workings of the RVM and charts, please let us know.