When the world is awfully close to another recession, where
would all the funds go to? A simple and conventional solution would be bonds,
more specifically, U.S. Treasuries. In spite of the latest Federal Reserve’s
bond purchasing exercise which may lead to the U.S. currency and all dollar‐denominated
assets to weaken, mainstream fund managers gravitates back to the mother of
safe haven asset: U.S. Treasuries.
In the short‐term, it may affect the steady flow
of funds into emerging markets. However, in light of “ultra” easy monetary
policy of major economies to boost their ailing economies, fund managers would
continue to look for alternatives. Long‐term effect of prolonged
quantitative easing would have an adverse impact on major currencies,
especially on U.S. dollar assets. Alternatively, emerging economies like
Malaysia could still offer foreign funds attractive investment returns
especially in terms of higher interest rate differential, a potentially
stronger ringgit (MYR), as well as a more resilient economy backed by on‐going
structural reforms. From an investors’ perspective, a safer bet and less risky
investment would be in Malaysian Government Bonds (MGS).
Currently, the one‐month average yield‐gap
between benchmark 10‐year notes of MGS and U.S. Treasuries remains at a large
180 basis points (bps) favouring MGS (Fig 1). As of Oct 16, the yield of 10‐year
MGS and Treasury notes are 3.48% and 1.75% respectively. The enlarged yield gap
is because investors were anticipating a third round of quantitative easing
(QE3), the lingering euro debt crisis, realisation of the adverse affect on the
U.S. economy if the “fiscal cliff” goes unresolved by year‐end,
higher probability of China experiencing a hard landing and the dismal outlook
of the global economy. As a result, the 10‐year Treasury note hit a
record low of 1.38% on July 25 from the year’s high of 2.38% on March 20. The
average YTD yield‐gap is 170 bps, favouring MGS, compared to 111bps for the
entire 2011. This explains why cumulative foreign holdings of Malaysian bonds
have reached a record high of almost RM200b as at end of August this year (Fig
2).
The fact that QE3 will continue indefinitely, it would put a
cap on US Treasury yields. Apart from the Fed’s Sept. 13 announcement on the purchase
of mortgage debt of US$40b every month, it also said that it would keep the
main interest rate at almost zero until at least mid‐2015. A
Bloomberg survey of economists’ projects the Treasury yield will be 1.76% by end
of the year, which reflect a limited upside from the current level and correspond
to investors’ flight‐to‐safety behaviour. We expect
the yield on MGS to be in the range of between 3.45% and 3.55% till year‐end.
Along with the higher global growth risk, we expect the average yield gap to
remain above 170 bps till end of 2012.
As ringgit‐denominated assets become more
alluring to foreign investors, the side‐effect is that it would exert
short‐term
pressure for MYR to appreciate. Already the MYR is currently trading at a six
month high of around 3.044 against the dollar. This is in line with our expectation
that volatility of the MYR/USD would increase and trade in a wider range of
3.00 to 3.10 following the announcement of QE3. Although capital flows could
potentially pose a challenge to the management of monetary policy, we believe
the rapid rise of the ringgit has now become BNM’s main concern, primarily to
preserve trade competitiveness. As a result, the frequency and amount BNM intervenes
to absorb liquidity has increased over the pass few weeks. Therefore, we
maintain our year‐end MYR target at 3.10.
Source: Kenanga
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