Fureyous

The global financial crisis continues to make front page news as governments around the world continue to announce stimulus packages and companies continue to retrench workers and show large losses or declines in profit results. During the first week of March in the USA the largest ever quarterly loss was announced by AIG at almost AUD$100billion. Equity markets around the world continue their poor run and high levels of volatility are likely to continue whilst the news continues to be poor and credit markets remain weak.

Recent actions by the Australian government include a $42billion stimulus package titled, ‘National Building and Jobs Plan’. Around $30billion is to be spent on infrastructure such as schools, housing, energy efficiency, and roads. Whilst ,these funds will not create immediate stimulus to the economy there is another $12.7billion consisting of tax bonus for working Australians, single income family bonus, farmer’s hardship bonus, and a Back to School Bonus and these payments are expected to be paid during March.

A positive sign for the Australian economy is the Reserve Bank choosing not to reduce the cash rate from its current rate of 3.25%; it is a positive sign as the Reserve Bank is clearly not in a hurry to drop rates. This is the first time in since August it has taken no action and the reason is that the Reserve Bank would like to wait a little longer to assess the impacts of the previous rate cuts before taking further action.

Current government forecasts for key economic indicators include an expectation of unemployment to increase from its current 4.8% to 5.5% by June 2009 and to 7.0% by June 2010. The government’s stimulus package is expected to support up to 90,000 jobs over this period.

The GDP figures released on March 4, showed a contraction in the December quarter of GDP placing Australian very close to a technical recession (i.e. 2 consencutive quarters of negative growth). Government forecasts are that our economy will grow by only 1% in 2008/09 and 0.75% in 2009/10. It is likely these will be revised down given the recent GDP result.

Overall, the Australian economy is slowing and news is not expected to be positive, however, compared to the rest of the world Australia is still far better positioned to cope with this downturn. Our interest rates are higher than overseas developed countries thus providing the Reserve Bank with more available leverage, our banking system is significantly stronger thanks to the strong regulation by APRA, and with our government running budget surpluses for many years, the government is now well positioned to spend money from a strong base.

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Back on January 20 in this blog I predicted that one of the trends of 2009 will be the demise of the hedge fund…

http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=a8uLPVL9X8yY

…I might be right. The hedge fund used to thrive in tough times…not this time.

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Capital protected products are in vogue at the moment thanks to the massive losses experienced and the scary economic times we face. Capital protection appears to come in all shapes and sizes…there are Constant Proportion Portfolio Insurance (CPPI) methods, sometimes called dynamic threshold management; futures and derivatives trading methods; Zero Coupon Bond and Call Option products; and then the plain vanilla good old fashioned Put Option.

It doesn’t really matter what method you use, at the end of the day they all attempt to replicate a Put Option. Unfortunately, with volatility at all time highs so too are the costs of put options. Many of the capital protection providers are trying to seduce the adviser by suggesting their method is not expensive but still provides adequate capital protection or low and behold a capital guarantee. Looks can be quite deceiving.

If a capital protected product is offering capital protection at a lower cost than a put option there is cause for concern. This is because you will be taking on counterparty risk by the provider so you better make sure they are financial sound.

On the other hand if the protection is more expensive than a put option then forget about it…buy the put option.

Lets expose what some of these methods really mean in this current environment….

CPPI or Threshold Management…this method is quite often cheaper than a put option…but guess what? It is inefficient and may not work…particularly in this environment! It is inefficient because the method requires selling down assets when prices are low and buying them back when they are high…selling low and buying high doesn’t sound particularly appealing. It may not work because if the sharemarket drops rapidly…like the 1987 crash and maybe many other examples…the protection provider may not have the chance to sell the growth assets and buy the bonds hence the protection fails. This is a real concern at the moment because the markets are very volatile and risk-free bond yields are extremely low. Therefore it doesn’t take much of a market movement to render CPPI useless so when/if it occurs…make sure your provider can still pay up.

Derivatives and Options methods…basically these methods replicate put options. If you sell a futures contract and purchase a call option you have effectively replicated a put option and guess what? It will cost pretty much the same without signficant arbitrage opportunities so make sure the costs are similar to a put option.

Zero Coupon Bond and Call Option…in this environment both of these items are very expensive…the bond has a very low yield which doesn’t leave much money to buy a call option to replicate your market returns. With an expensive call option overall there’s not much joy in this method.

Put Option…one transaction that provides the proteciton but is still expensive due to volatile markets.

Overall, in this environment with the cost of protection at highs, tactically, I would rather be a seller a than a buyer of volatility and that is what you are doing when you buy protection. Protection is expensive and it is important not to be seduced with lower cost inefficient, risky alternatives.

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So the RBA didn’t change rates and the yield curve was no where predicting it this tie around. As a result of the no change the yield on the September 09 Government bond has promptly increased by around 10bps to 2.71%. Looks like a rate cut next month???

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After a disastrous Wall Street, thanks to a record loss posted by AIG (-US$62billion for 1 quarter…Yikes!), and Wayne Swan’s warning about the slowing Australian economy a couple of days before the latest GDP results, Australian Government Bond Yields have dropped signficantly and the September 2009 Bond is now trading on a yield of 2.61%.

Maybe a 50bps drop by the RBA is looking a little more likely!

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Its the day before the RBA announces its latest cash rate so I thought I’d come in with a late prediction.

Its pretty simple really…September 09 Government Bonds are trading at a yield of 2.82% today so the market is expecting one of two rough possibilities…

1. the Reserve Bank drops the cash rate by 50bps to 2.75% and keeps it there for the next 6 months, or
2. the Reserve Bnak drops it by 25bps tomorrow to 3.00% followed by another 25-50bps between April and June and keeps it at 2.75% through to September

I’m not sure what the probabilities are between these 2 possibilities, but I predict that option 2 is most likely. So for the record, the RBA will drop rates by 25bps on March 3 and will probably drop another 25bps in April. I personally believe these won’t be the only rate drops this year but the market is expecting different so who am I to disagree.

With August 2010 bonds trading at a yield of 2.76% it appears the market is a little more optimistic than it was a few weeks ago and perhaps expects a cash rate low of only around 2.5% which is a significant increase from a previously expected low of 2.00%. Perhaps things are looking up in Australia.

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