JCB ACTIVE FUND IS UP 8.54 % (GROSS) OVER 15 MONTHS SINCE INCEPTION IN DECEMBER 2014, RUNNING A PORTFOLIO OF LONG ONLY AAA AND AA+ RATED GOVERNMENT BONDS. NEGATIVE RATES SEE AUD SET TO RALLY, BANK FUNDING TO CAUSE OUT OF CYCLE RATE HIKES, RBA FORCED TO ACT

Europe, Japan, Switzerland, Sweden and Denmark are all very real and developed places. They also all have negative interest rates. This trend is both powerful and global. This is not happening in Timbuktu, this is happening in Paris, Tokyo, Zurich and Stockholm. Negative interest rates are Central Bankers new tool in fighting anaemic growth and low inflation. You should not dismiss them. They have vast consequences for market valuations and discount rate assumptions. Those who dismissed Quantitative Easing (QE) 10 years ago failed to grasp the huge implications QE would have on markets and financial asset returns to their peril.

Under negative interest rates, domestic banks are charged by their Central Banks to keep funds on deposit. The idea is to penalise banks for holding cash which could be lent into the economy to encourage investment and consumption. This results in much of these domestic bond markets trading at negative yields, depending on the bonds maturity. Investors in these regions are now forced to accept negative returns on their bond portfolios or find alternate sources of yield. Australia stands out like a shining light. AAA rated, a $700bln deep and liquid government bond market, Westminster legal system, and most importantly a Central Bank with ammunition to continue to cut rates. Here is where this becomes self-reinforcing. As international buyers purchase Australian Bonds, they need to buy AUD currency to settle the trades. This is part of the reason the AUD climbed so high after the GFC. Not only were investors importing capital to fund mining capex, but they were also buying Australia’s newly minted budget deficits at around $50 billion a year, which required purchasing AUD to settle the transactions.

This new development coincides with skyrocketing bank funding costs. Around 30% of bank funding is sourced in international markets, where spreads have widened significantly as credit markets continue to suffer, resulting in higher borrowing costs for the banks. Do you expect the bank to absorb these higher costs? The 3rd certainty of life, after death and taxes, is that banks will pass these costs onto customers to maintain margins (also be wary of highly complex bank products promising great things, think CDO’s – classic end of cycle trick). Westpac already raised business loan rates last week and we would expect mortgage books will be next for out of cycle rate hikes.

This tightening in financial conditions, along with a higher AUD, will be unwelcome with the RBA, who will be forced to cut rates in response. A rate cut will attempt to help Mum’s and Dad’s from higher mortgage rates at a time when the economy is quite fragile, although banks will not pass this cut through in full, rather restoring their net interest margins. A rate cut also removes the yield from Australian Government Bonds (resulting in significantly higher bond prices in the process), thereby reducing the pressure on the AUD currency, allowing the economy to rebalance and resort better conditions for future growth.

Turning quickly to international events the rise of Donald Trump looks look to be gaining momentum. Markets hate uncertainty and in Trump they will get plenty. One of his first orders of business is to fire Janet Yellen as FOMC Chair. Combine this with Trump’s finger on the nuclear trigger and we could be in for quite a volatile ride! JCB also believe the European migration crisis can be the theme of the year for markets. Desperate people will be forced out of Syria via Turkey and into Greece at a time when Greece is again running out of money and incapable of processing them in a secure manner. We unfortunately expect more flash points of terror and violence like Paris, Cologne and Calais when the weather improves and more people attempt the journey. This can divide the European left and right and strain the Eurozone project considerably. It will also have a large impact on the BREXIT referendum of June 23rd