JCB RETURNS +3.06% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• AUSTRALIA’S ECONOMIC NEUTRAL RATE FOR RBA CASH BETWEEN 1.75% AND 3.50%
• EXPLICIT RBA SPEECHES CRUSH ANY ‘’RATE HIKE’’ CHATTER IN MARKETS
• $AUD RALLY IS HIGHLY DEFLATIONARY UNDER RBA INTERNAL MODELS
• TRUMP VERSUS CONGRESS (GOVERNMENT SHUTDOWN)
• NORTH KOREAN INTER CONTINENTAL MISSILE TESTS – 2 YEARS AHEAD OF CIA SCHEDULE
• FUND PERFORMANCE

Economic Neutral Rate for RBA between 1.75% and 3.50%

The release of July RBA minutes contained a reference to a ‘’3.50% neutral rate’’ which caused significant volatility for short-dated bonds and AUD FX over July. In direct response, the AUD/USD exchange rate rose above 80 cents. The markets were correct to change forward pricing expectations around the RBA cash rate ahead of receiving clarification from the RBA regarding this statement. In the days after the minutes were released, markets priced in more than a full RBA rate hike by May 2018.  JCB estimated that this ‘’neutral rate’’ reference was included in the RBA minutes to remind markets that interest rates will be lower for a significant period. This proved correct after hearing clarification remarks from RBA Governor Lowe. However, this has sparked an interesting debate amongst economists as to what is the current Australian neutral rate.  JCB believes the RBA assumption that ‘’neutral’’ at 3.50% is absurdly high given the current debt loads in the domestic economy. We have written extensively about the ‘’income shock’’ that material rate hikes would unlock on indebted households and we have examined this secular theme with our Advisory Board on numerous occasions. Our best sense is that rates will remain low for an extended period.  Deutsche Bank published a report in late July suggesting the neutral rate could be as low as 1.75% (remembering that the ‘’neutral rate’’ is that rate at which interest rates are neither accommodative nor restrictive in the economy).

Explicit RBA speeches crush any ‘’rate hike’’ chatter in markets

LOWE: SOME COVERAGE OF NEUTRAL RATE MISINTERPRETED OUR INTENTION

RBA’S LOWE: WE DON’T NEED TO MOVE IN LOCKSTEP WITH GLOBAL PEERS

LOWE: WOULD BE BETTER IF A$ IS A BIT LOWER THAN IT IS

The key takeaways from Lowe’s speech were:

• The RBA still sees 0.6% of slack in labour market as it relates to the unemployment rate
• If low wage/inflation persists, the reaction from a pure inflation targeting central bank would be to ease monetary policy. We (JCB) see this (an ease) as unlikely ex an external shock
• But the RBA has “a flexible medium-term inflation target that allows financial stability considerations to be taken into account in the setting of monetary policy”
• “…seeking a more rapid pick-up in inflation through yet further monetary stimulus (would) likely to add to the medium-term risks.”

Governor Lowe went on to stress that the RBA did NOT follow other economies to zero interest policy rates and Quantitative Easing and hence has nothing to undo as those emergency policies are unwound offshore. He essentially broke any perceived linkage between monetary policies of Canada and Australia (despite the economic similarities between Canada and Australia – both being a commodity based nation dependant on a large trade partner). Many global hedge funds looking to profit from speculating that Australia would follow the Bank of Canada into a rate hiking cycle were badly hurt as Governor Lowe explicitly changed market expectation.

AUD rally is deflationary under RBA internal models

We see the above pick up in domestic inflation unlikely until the USD currency can find its feet.  The 5%+ jump in the Australian dollar over the past months could mean a 0.5 per cent decline in core inflation over the next three years, according to internal RBA’s currency modelling.  Traditionally, a higher currency has a direct impact on a country’s inflation print (via tradeables inflation) but recent shifts in the retail landscape mean this relationship has become more complicated.  A general rule of thumb for measuring the impact of currency moves on inflation, according to research by the Reserve Bank of Australia, is that a 10 per cent move in the currency would add or detract 1 per cent to annual inflation evenly weighted over three years.  The recent rise in the Australian dollar has pushed the Trade Weighted Index – an average of currencies reflecting the sum of Australia’s exports and imports of goods by country – 5 per cent higher since the RBA’s last monetary policy statement.

Trump versus Congress (possible US Government Shut down)

The West Wing looks to be imploding after the events of the last few weeks.  Tax reform has been pushed to after the summer recess (Congress back on Sept 5th) and we remain concerned that the debt ceiling debate and possible government shut down (early October on current spending) will be used by a desperate Trump as a bargaining tool against Republicans, trying to force their hand to support unfunded tax reform. A government shutdown would be a powerful motivator as Congress remains mindful of looming mid-terms elections into 2018 (something that doesn’t concern Trump at this point – sadly he isn’t up for re-election until 2020). Trump has nothing to lose. JCB expect this could be a potential source of financial market volatility leading into this period, with highly binary outcomes for risk depending on tax reform passing or failing before Congress goes into mid-term election mode.

North Korean Inter Continental Missile Tests – 2 years ahead of CIA schedule

North Korea.  The recent Inter-Continental Ballistic Missile (ICBM) tests by North Korea have rattled defence feathers in Washington. This technological leap forward from North Korea is 2 years ahead of a suggested CIA development timetable. On this timetable the North Koreans can arm an ICBM with a nuclear warhead capable of hitting Middle America (Chicago/Denver etc) within 6 months.  After the initial Mar Largo meeting between Trump and Xi Jinping of China, CIA satellites noted a significant drop in trade activity between North Korea and China. This was considered a positive development in that China could ‘’quarterback’ as a go between to defuse geo-political tensions. In last few months trade activity has returned to normal highlighting China’s unwillingness to play a ‘’middle’’ role in this increasingly difficult geo political area. This again looks like a possible source of significant volatility for markets in coming months. We have written previously at length about Trump, a president that is seemingly totally self-serving, who may require a ‘boost in the polls’ from playing the strong man leadership role. A credible nuclear threat against the US is the perfect platform to divert the publics attentions from a so far failed presidency (combined with lowest ever approval ratings) that’s only real achievement to date is appointing a Supreme Court judge whilst repeatedly tarnishing the highest office in the land.

Portfolio Update for July

After the pullback in Government Bond markets in June, valuations had improved considerably considering global and domestic data still remained patchy, inflation data remained weak, geo-political risks remained elevated and bond market seasonality turned positive. JCB funds added additional duration to portfolio’s, removing a structural defensive position which is a favoured portfolio structure whilst also removing some additional semi government and supra national exposures in favour of ACGBs in expectation of a bond market rally over July and August.

Two events over the month gave global momentum accounts and CTA speculative accounts to significantly sell bonds and test lower prices in Australian Government Bonds. Firstly the hike in interest rates by the Bank of Canada were interpreted as a precursor to higher rates from all Central Banks (clearly wrong, as crushed by RBA Lowe’s explicit comments). This was followed closely by the RBA statement discussing the 3.50% neutral rate as we have discussed above in the market review also added to immediate selling pressures. On the day the RBA minutes were released the markets recorded the largest volumes seen since 2011 in Government Bond futures. These global momentum and CTA accounts pushed hard to establish a trend to lower prices, repeatedly selling securities and futures contracts in shorted dated instruments towards the lowest valuations of the month, flattening the yield curve in the process. This proved a losing strategy for the momentum crowd as the improvement in valuations encouraged significant buying with bond valuations holding ground and closing with a slight gain over the month. JCB added significant curve exposures to monetise existing positions in the portfolio into this opportunity.

From a technical perspective the candles at the extremes of this choppy range showed extremely long wicks, highlighting the volatility towards extremes with stop loss selling/buying quickly being retraced. The market managed to withstand this heightened volume from the sellers, however, JCB portfolio’s remained on high alert for a possible move to lower prices and stood ready to hedge accordingly to protect capital should the momentum speculators gain the upper hand for a short period.  This lead to the portfolio being increasingly active over the month to protect capital as required. Over the month the portfolio managed to outperform its index by 0.05% on a gross basis.