JCB SECULAR THEME – GLOBAL INTEREST RATES CONSOLIDATION AFTER LONG TREND WITH RBA ON HOLD AT 1.50% FOR 2017

• US FEDERAL RESERVE TO HIKE IN MARCH, BONDS HISTORICALLY RALLY AS FED ''WALK THE WALK'', RATHER THAN ''TALK THE TALK''
• IN THE 2004-2006 US FEDERAL RESERVE HIKING CYCLE OF 4.25% (1.00% TO 5.25%), US 10 YEARS GOVERNMENT BONDS ONLY MOVED 0.37% OVER THAT PERIOD OR LESS THAN A 10TH OF THE CENTRAL BANK RATE. IS THIS TIME DIFFERENT? BIG IMPLICATIONS FOR BONDS, YIELD SENSITIVE EQUITIES AND REIT’S
• ‘’I’M NOT PREDICTING IT, I’M OBSERVING IT.’’ EUROPEAN DEBT MARKETS STARTING TO PANIC
• RECORD $20 BILLION DEMAND FOR NEW AUSTRALIAN GOVERNMENT BOND
• POSITIONING UPDATE, SHORT POSITIONS CONTINUE TO GROW AS THE BOND MARKET RALLIES

US Federal Reserve to hike in March, bonds historically rally as Fed ''walk the walk'', rather than ''talk the talk'' -

JCB expect the US Federal Reserve (Fed) to hike interest rates at it's upcoming March meeting. If recent history is any guide, expect longer dated bonds to perform well after the rate hike. That is critical if you are a bond investor, invested in yield sensitive equities, REIT's or thinking about fixed or floating loan exposure.

When the Fed hiked in December 2015, 10 year Government Bonds went on to rally from 2.30% to 1.66% (lower yields equal higher prices) in the following two months in early 2016. In the two months since the rate hike of December 2016, 10 year Government Bonds have rallied from 2.60% to 2.32%. So whilst the ''funding rate'' is moving higher, longer dated bond rates can often move the in the opposite direction. There are a number of technical reasons for this beyond the scope of this update, however, this is primarily due to the markets estimation of inflation expectations changing with an active vs dormant Fed. A Fed sitting on their hands whilst the economy is heating up is a concern for markets, who worry inflation may accelerate and the Fed may ''fall behind the curve'' in delaying action to cool the economy. When the Fed actually lift funding rates the market acknowledges such moves by re pricing longer dated debt securities.

In the 2004-2006 US Federal Reserve hiking cycle of 4.25% (1.00% to 5.25%), US 10 years Government Bonds only moved 0.37% over that period or less than a 10th of the Central Bank rate. Is this time different? Big implications for bonds, yield sensitive equities and REIT’s.

In the last full Fed hiking cycle of 2004-2006, the Fed moved the funding rate from 1.00% to 5.25% over a 2 year period. The first hike in that cycle was on June 30th 2004. 10 year US Government Bonds yielded 4.87% in mid June of that year, just shy of the first rate hike. By the end of the hiking cycle on the 29th of June 2006, the US Fed funding rate had moved an astonishing 425 bps to 5.25% (sowing the seeds for the GFC as to much leverage was created at low interest rates), a day short of 2 years later. Over that 2 year period the 10 year US Government Bond yields was higher by only 37 bps to a yield of 5.24% or less than a 10th of the move in funding rates. This is very counter intuitive for many casual observers of the bond market, who assume a hiking Fed is universally bad for all bonds. Early in this hiking cycle US 10 years Government Bonds rallied significantly, despite US Fed rate hikes. Over the first 3 rates hikes from 1.00% to 1.75%, 10 year Government Bonds rallied from 4.87% to 3.88%.

It is important to consider the hiking cycle in full and it's impact on differing asset classes. When the Fed are hiking, they are trying to slow down the economy by making the cost of funding capital more expensive. This usually requires more than one adjustment, and each adjustment comes with a significant lag to the real economy. The more the Fed hike funding interest rates, the more they are ''tightening'' financial conditions in the economy through the funding (cost of capital) mechanism. Whilst funding rates are higher for borrowers (making loan servicing more difficult), rates are also higher for lenders, and thus international capital flows from other currencies into USD to benefit from higher interest rates as a lender. This usually pushes the USD currency higher, further tightening financial conditions as imports are more expensive and exports are less competitive.

Early in this cycle, all we get is ''talk'' from the Fed. As there is little Fed action (''walk the walk''), this tends to be the period where all bonds and yield sensitive equities pullback whilst growth assets continue to thrive, exactly what we observed in the later part of 2016. Once the hikes actually commence, low quality loans start to sour, as the most indebted feel the pinch of higher funding costs first. Short dated bonds suffer, however longer dated bonds will usually remain stable or perform. Growth assets tend to slow but can continue to perform. As the hikes continue and cross the ''neutral rate of funds'' (the rate that takes policy from accomodative to contractionary) the economy starts to slow, as debt servicing costs continue to bite. Discretionary spending slows as a result, less spending leads to lower business revenues, which brings job cuts and the spiral becomes self fulfilling. This point in the hiking cycle has an adverse effect on growth assets and long dated bonds do extremely well, in anticipation of a deleveraging cycle and deflationary type conditions experienced in a recessionary period.

Of course ideally central bankers would stop at the neutral rate and avoid tipping the economy into a contractionary phase. Unfortunately, no one knows what the neutral rate actually is - it is different in every cycle. We do know that global debt has exploded from $140 trillion pre GFC to $230 trillion nearly a decade on. Unquestionably, we now live in a very fragile system that relies on both the free availability of credit AND low interest rates to fund that credit. If either one of those to pre conditions is removed the system is severely challenged. JCB believes the new neutral rate is significantly lower than previous cycles

''I'm not predicting it, I'm observing it'' George Soros -

Whilst the markets are mainly focused on Trump and the US Fed, a sobering environment is brewing in the European debt markets. Concern around elections in Holland, France and Germany has seen dramatic under-performance of some European debt. Some of these moves have not been witnessed since the height of the Eurozone debt crisis. Debt markets are becoming extremely nervous about Europe and the stability of the Euro. Could this all blow over if we get a market friendly political result ? Absolutely. Except populism is very anti-establishment, because the establishment have failed the middle classes in the west. The Eurozone project is the antithesis of establishment. European election polls remain volatile but this situation requires ongoing monitoring.

Record $20 billion demand for new long dated Australian Government Bond  -

Australia launched a new November 2028 Government Bond in late February, via a syndicated new issue (this is essentially a debt market IPO). Orders for the new bond broke all existing records for a new issue Australian Government bond - exceeded $20 billion in less than 24 hours. This demonstrates significant global demand for long dated bonds with higher yields after the pullback post US election. The government issued only $11 billion, leaving substantial demand unsatisfied.

Positioning update, short positions continue to grow as the bond market rallies -

JCB noted in our January update that speculative short positions in US interest rate futures are at a once in a generation extreme. Every time we have previously seen high speculative short positions the market has experienced a substantial squeeze, stopping these positioning at losses and cleansing the positioning bias in the process. These speculative positions continued to climb through February, despite the market performing. Could the Fed rate hike in March be the catalyst to generate the squeeze? This sounds counter intuitive but as we highlighted previously, long dated bonds have historically performed very well after rate hikes.

JCB continue to believe that this heavy positioning skew will remain a tactical opportunity for active managers in the near term. It will require a spark, but the positioning is extreme and tinder dry (plus expensive to carry paying away bond coupons). This type of positioning build up will continue to drive market volatility inside a secular environment where rates are unlikely to break the ranges of the last few years. After a long period declining rates, a period of consolidation is highly likely. Long term trends rarely end and immediately reverse. The bond market has essentially been on a large round trip through Brexit and the election of Donald Trump, but net net it hasn't really moved when viewed on a longer time frame.

FUND UPDATE FOR FEBRUARY

The JCB active fund returned 0.58%, outperforming its benchmark by 0.44%. The fund benefited from intra month volatility driven around the pricing of the new syndicated new issue November 2028. It also benefited from performance of some short dated supra national bonds. The fund remains under weight duration, however, we continue to look for tactical opportunities to drive additional performance and protect capital.