The Daily Update - What would the martians think...?

Thirty years ago today the Soviets launched the then biggest space station, Mir, and just yesterday some reports suggested that NASA cut the video feed from the International Space Station due to a UFO entering the Earth's atmosphere. If that is the case and martians did come to Earth to visit, they should jump in a helicopter instead, if Cleveland Fed Loretta Mester’s surprising statement is anything to go by.

Commenting on Australia’s ABC, Mester said with quantitative easing having “proven to be useful”, helicopter money “would be sort of the next step if… we wanted to be more accommodative” in the event the US suffers a recession, as there is very little ammo remaining. She spoke of her concerns of staying at zero rates for too long and the subsequent “financial stability risks”, later adding that she believes the FOMC committee are not behind the interest rate curve. With the unknown risks of the UK exiting the EU, Mester said the committee will continue to assess the impact in terms of economic conditions and the effect on the US economy. The futures market currently is not pricing in a rate hike until November 2017 at the earliest, and we reiterate our belief that the Fed will struggle to raise rates this year.

Meanwhile, back in Britain, as new Prime Minister Theresa May readies her cabinet to prepare for “Brexit means Brexit” we heard from the central bank, which kept rates on hold at 50bps. This announcement caught some market makers off-guard as consensus was for a 25bp cut. The pound surged to as high as 1.3475, eventually settling ~1% higher against the dollar on the day (at time of writing). The BoE clearly indicated that it will take action at the next meeting in August, no doubt armed with more post-referendum data releases to support the decision. Could we see the BoE following in the ECB’s footsteps by adding corporate bond purchases to its books?

Elsewhere, for the first time ever, a 10-year benchmark Bund has been issued with a negative yield! In fact even more surprising is the first ever non-financial company, Deutsche Bahn, issuing the first ever negatively yielding euro bond earlier this week. The Aa1/AA rated EUR 350m 5-year deal (initially marketed at EUR 250m) came to the market with a 0% coupon and -0.006% yield; the issue was surprisingly well absorbed. If yields continue to fall investors holding such paper will benefit from the capital gains, which will offset the interest rate cost; the pain will come when yields stop falling or indeed rise.

At Stratton Street, we do not hold any negatively yielding paper in our portfolios; we prefer to identify issues which have adequate spread cushion. The Deutsche Bahn issue is currently trading at under 50bps over Bunds, similarly rated 5 year bonds trade at just over 70bps according to our proprietary Relative Value Model, thus suggesting that the bond is “expensive”.

We would rather consider new issues from the likes of Taqa, an Abu Dhabi sovereign wealth holding company. The 4.375% 2026 bond, rated A3, was issued at ~290bps over UST. Since its launch around a month ago, the bond has performed extremely well, gaining almost 9 points, tightening of over 100bps and currently trading at a yield of 3.4%. The bond continues to offer around 50bps spread cushion, but we will look to rotate out of this holding into a more attractive position as it approaches fair value.

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