The author is an analyst of NH Investment & Securities. He can be reached at firstname.lastname@example.org. -- Ed.
Both safe and risky asset prices plunged last week on concerns over a slowdown in the real economy. But, an aggressive policy response by governments should lead to a drop in cash demand, helping to stabilize yields. And, foreign investors are likely to re-enter the KTB market due to rising arbitrage opportunities.
Problem lies in real economy, not financial market
Last week, the prices of both safe and risky assets plunged. However, we note that the price drop was not caused by a liquidity crunch within the financial market. Although the Libor-OIS spread jumped to 68bp last week, this was due to a sharp drop in OIS interest rates, rather than a rise in Libor rates. As of yet, the financial market turmoil does not seem to be evolving into systemic risk.
The current fear in the market is not due to financial conditions but rather concerns over the real economy. Over the weekend, amid accelerating Covid-19 cases in Europe, the spread of the virus also picked up pace in the US. Against this backdrop, a fall in oil prices spurred demand for cash, leading to panic selling across all asset classes.
In response, the Fed basically announced a resumption of QE by outlining a plan to expand its T-bill purchase program to include the purchase of coupon-bearing securities. Specifically, the Fed plans to purchase US$500bn worth of TBs and US$200bn worth of mortgage backed securities on Mar 15. It also cut the FF rate by 100bp ahead of the March FOMC meeting. We view it as a preemptive response to the possibility that distressed firms will find it difficult to raise funds while the economy is slowing down. US TBs are still attractive in that concerns over a recession in the real economy continue to linger. Of note, last week’s rise in US TB yields was in part due to high demand for unwinding pair trades (long TBs-short futures), but the Fed’s massive QE plans should stabilize yields.
Foreigners to re-enter KTB market on rising arbitrage opportunities
Last week, KTBs, a major safe asset, experienced aggressive selling amid rising foreign demand for cash. On Mar 13, foreign investors sold a total of 320,000 contracts for 3yr and 10yr KTB futures. In the process, the CRS rate, which remained stable despite massive foreign selling of KTB futures at the end of last year, plunged, entering negative territory. This is the first case of a (-) reversal in CRS rates since Nov 2008 when the global financial crisis occurred.
However, with the Fed set to increase dollar liquidity via massive QE, foreign investors’ borrowing rates have declined and hedging premiums have jumped to 155bp, leading to greater arbitrage opportunities. With the procurement rate taken into account, an expected return of 2.36%p is possible by investing in 10yr KTBs (based on Libor rates before the surprise Fed cut on Mar 15). Thus, foreign central banks and sovereign wealth funds, which are major players in the KTB market, will likely expand their presence in the market and the outflow of foreign funds should end. The possibility of Korea’s benchmark rate hitting the 0%-range has also increased significantly, providing further rationale for investing in long-term KTBs.