Mainstream talking heads also continue to dismiss how interest rates may affect security prices and the economy. The prevalent belief is that interest rates will remain either perpetually low and that an increase in interest rates will hardly impact on the stock markets.
Even the former value investor Mr. Warren Buffett understands the sine qua non role played interest rates to investments. At CNN Money, in 199 Mr. Buffett wrote[1], (bold mine)
To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.Consequently, every time the risk-free rate moves by one basis point--by 0.01%--the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect--like the invisible pull of gravity--is constantly there.
Mr Buffett goes on to cite 1964-1981 where rising interest rates depressed investments, and reversed from 1981 onwards.
As I previously pointed out Discounted Cash Flow analysis of any investments are heavily interest rate sensitive[2] and so as with the debt and interest payments affecting these.
Last week the Philippine government raised $ 1.5 billion at record low rates via the global markets[3]. Indonesia, despite the financial market pressures equally raised $4 billion but at much higher rates[4]. Indonesia’s foray into the global debt market has been part of the record Rp 357.96 trillion ($29.2 billion) the government plans to raise this year. Both Indonesian and Philippine bonds were reportedly oversubscribed.
Bizarrely, yields across the Philippine treasury curve jumped significantly higher after the successful bond offering.
Stunningly yields of short term one month (upper left) and six month (upper right) treasuries soared by about (TWO HUNDERED) 200 and over (ONE HUNDRED) 100 basis points! Last week’s spike in short term yields has even breached past June levels!
Meanwhile yields of long term 10 year (lower left) and 25 year bonds (lower right) rose by much less but still has risen significantly to reach the June levels.
To me, this raises many questions. Why hasn’t the bullishness of foreigners spilled over to the largely closed Philippine sovereign bond markets which had been in tight control by the banking and government? Could this be that some major local financial institutions appear to be feeling the heat from the recent market pressures? Which institutions may have been affected by the recent spurt of yields? Will the damage be contained?
And…will this be like June a knee jerk reaction or will this represent a new trend? Or will last week’s action serve as portent to the culmination of the convergence trade[5]—the grotesque mispricing of domestic bond markets that has underpinned the current bubble?
If last week’s trend persists then we will see a flattening of the yield curve, which means lesser motives for banks to lend.
Philippine treasuries remained as the only financial markets unscathed by the recent strains; apparently, not anymore.
Getting to be a lot interesting, no?
Unlike the Philippines, Indonesia’s $ 4 billion bond sales did push 10 year local currency bond yields down by about 16 basis points over the last few days.
But all three ASEAN majors, has seen rising yields be it Thailand and Malaysia or even Singapore (down by about 26 basis points from August 2013 highs) and the South Korean counterparts (also down by 12 bps from August 2013 highs)
ASEAN currencies continue to exhibit sustained signs of deterioration. While the USD-Indonesian rupiah (upper left) had an interim late week decline perhaps due to the dollar bond sale, the weak rupiah vis-à-vis the USD remains at a one year high.
Meanwhile, US Dollar continues to strengthen relative to the Thailand baht (upper right) and the Philippines peso (lower left). The US dollar has already broken beyond the September in terms of the rupiah and the baht. The US dollar is also at the verge of a breakout against the peso from the September levels.
The USD-Malaysian ringgit has also staged a weekly decline, nonetheless general trend remains in favor of the USD. The same holds true for the USD-Singapore Dollar but not the USD-South Korean won which has been rallying through the year.
In sum, currency conditions of most ASEAN majors have likewise been exhibiting symptoms of sustained market stress.
This chart by the Philippine Phisix and Thailand’s SET continues to fascinate me. The reason is that both seem as a mirror image of the other. I thought last week that the correlation might break since the SET greeted the New Year or the first day of the year with a 5.23% quasi-crash while the Phisix continued to struggle her way up.
But I guess following this week’s performance, where the Phisix has once again revealed signs of weakness, these two benchmarks may re-converge soon.
Among ASEAN majors it has been Malaysian stocks as measured by the KLCI that have remained defiant of the regional weakness as the KLCI continue to drift at near record highs. Although Indonesian and Singaporean stocks as measured by JCI and STI respectively has regained some grounds they largely remain in doldrums. Meanwhile despite the rising won, the South Korean KOSPI has been sharply deteriorating over the last month.
Whether ASEAN’s market strains are being induced by the Fed’s tapering or not, or from the recent tremors in China’s bond and stock markets or from domestic politics, rising interest rates will put ASEAN’s debt conditions under the spotlight.
And it’s not just bonds, currencies and the stocks. ASEAN’s credit worthiness has been under scrutiny, as measured by Credit Default Swaps (CDS) where the probability of default has been on the rise.
As a recent Bloomberg report puts it last Wednesday, “cost of insuring Malaysia’s sovereign debt climbed to a two-month high” while for “Thailand, the contracts climbed to a four-month high and in the Philippines they reached a level not seen since October.”[6]
Will I recommend buying Philippine or ASEAN stocks under current environment? Generally no but with a possible conditionality based exception: the mining industry.
As for the general markets, I will recommend refraining from catching falling knives and heed the sage of Omaha, Mr. Warren Buffett’s judicious advice, “if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line.”
[update: I adjusted for the font size]
[update: I adjusted for the font size]
[1] Warren Buffett Mr. Buffett on the Stock Market The most celebrated of investors says stocks can't possibly meet the public's expectations. CNN Money November 22, 1999
[2] See Phisix: BSP’s Tetangco Catches Taper Talk Fever July 29, 2013
[3] Wall Street Journal Philippines Raises $1.5 Billion Via Global Bond January 5, 2014
[4] Jakarta Globe Indonesia Sells $4 Billion of Global Bonds for Dollar Supply, January 8, 2014
[5] See Phisix: The Convergence Trade in the Eyes of a Prospective Foreign Investor November 11, 2013
[6] Bloomberg.com Malaysia Default Risk at 2-Month High on China Slowdown Concern January 8, 2014
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