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Thoughts On SHIBOR And Fed

|Includes: AGG, DIA, Hang Seng Ftse/Xinhua China 25 Index ETF (HGSFF), TLT

Thanks friends for your support in my premier blog & tweet. Please continue to exchange views.

Please note that while I may discuss a particular asset class in each blog, a portfolio should consist of well diversified uncorrelated asset classes. Personally since 2009, equities do not account for more than 1/3 of my portfolio, within which only a minority in HK/China.

I'll share my thoughts on interest rates in this blog. Though the first part of SHIBOR might be of more interests to my friends in HK, please read through the second part on Fed. That's more useful intellectually and for a longer term investment.

Major assets continued the macro adjustments as discussed in the last blog. The weakness in HK/China is worse than I expected. Surface reason due to high SHIBOR, deeper reason is the stronger reform intentions to the political & thus financial system.

SHIBOR started to come off in the last 2 days, think that to continue moderately, say for another 1-2 months before it settles on PBOC intended levels. Current 3mth SHIBOR at 6% when CPI is in a downtrend with 2.1% latest does not make sense. That's why SHIBOR comes off, SHCEI or bank requests is just a precipitator. But whether 3 mth SHIBOR settles to prior 4% levels is worth monitoring. From chart 1, you can see that PBOC's contrarian actions was actually behind the mkt. So SHCEI would be disappointed if it depends on PBOC for a quick fix, that's why the panic sell-offs recently. PBOC injected liquidity to specific banks last night, but I view that a one-off tightness soothing action, an overall injection of liquidity not expected because the reform intentions are still intact. But think we have seen the worst of SHIBOR for the time being, esp after June when the half year end balance sheet pressure eases.

Mindful that the moderating SHIBOR only takes away the acute negative force on SHCEI. The deeper systematic reform, which exposes the weak mgt of majority of China companies in difficult times, will cap the upside for SHCEI. The mgt issue, together with the weak political outlook of HK, caused me to underweigh China for the past 18 months - I'll discuss further in future blogs. Having said that, HK becomes so dirt cheap that I had started some trading positions for rebound.

HK is dirt cheap in terms of PE as discussed in last blog. It is also attractive at dividend (historical) of 3.8% in the absence of a major crisis (Japan is at the back of my mind as the next crisis candidate, but think we still have some time). Earnings and Dividend both show mild downward trend in recent quarters, but don't think the slope to worsen. See Chart 2 above.

But "cheap" or "attractiveness" is relative to cost, which is interest rates for equities. Chart 3 plots out HSI's excess dividend (over 5 yr HK "Govt" yield). The following observations are interesting:

· recent divergence between dividend yield and excess dividend - due to rapid rise of Govt yields in the past 2 weeks.

· current excess dividend not as "dirt attractive" compared to last HSI major low in year 2011 & 12 - this might push HSI to 18,000 if yield continues to rise rapidly, yet I do not think the recent pace in rates to continue. And an expected gradual lowering SHIBOR should help HK rates.
· inspite of the above, current excess dividend is very high in a 20 years context. Excess dividend had been elevated after 2009 due to QE (and thus artificially low yields), it is normal for that to gradually settle lower now that QE is expected to be tapered. So lowering excess dividend from here not a reason for price sell-off within the long term timeframe.

But the HSI mkt tone is weak due to sentiment impact from the China mkt. So expect this as a rebound with first selling pressure at 21,000. Nicer base to take a few months from here to 18,000. Upside in the next 6-12 mth I still see 22,000 or above when PE goes to more normal levels say 13x.

Stock pick is difficult though. I would pick the decently managed companies with upward earnings & price trend still intact. I would avoid China real estates, impact to them from the financial reform to surface later. Some might even be the target to be punished in the next round. Crowded space and heavy debted ones not to mention as discussed in last blog already.


Fed is more interesting to me. UST moved faster than I expected esp after 2.2% taken. It also stayed above 2.5% critical level. Next target 2.8-3%. Staying there would mean that the bond bull trend since 2007 has turned. Is the bond preparing to turn the 30 year bull trend since the 80s? Are we stepping into a clearer stagflation era? We have to observe 3.5% handle. That is another topic for future blogs.

Then is the bond mkt reacting too much to Fed? In terms of pace, I think so. In terms of magnitude, maybe a yield level of 3% is not too worrying for Fed as seen in 2009-11. We should have a clearer clue from the July 10th Tsy auction.

I had assumed the Fed tapering as a gesture before Bernake goes in my last blog. But the mkt reaction prompts me to research deeper within Fed. I found quite some preparatory research papers from Fed in the last 24 months. So now I think Fed's tapering is part of its serious Keynesian plan. Sorry Mr Bernake, I had misunderstood you.

Several Fed papers modelled on the impact of QE to interest rates. Conclusion is roughly 65bp to 10 yr Tsy; 40bp from QE1, 20 from QE2, minimal effect from later QEs. Now that Tsy has moved 100 bp from recent low, one can say that the current Tsy level has taken out all the QE artificial effects.

One paper confirmed the useful information from the yield curve shape for the economy and policy makers. This has been academic & mkt consensus for long. Actually yield curve shape was a reference in many Fed meetings. So taking out the artificial effect ensures Fed still has the useful information for its next major policy step, ie when to hike rates. (I'm not saying Fed to hike rates soon, still think that earliest is 2015).

Then some papers discussed the impact of extreme low bound rates to the economy. Conclusion is fiscal impact in a low bound environment is much less effective than in normal rates era. Fiscal deficit is a big concern to Fed since Greenspan & Clinton. So this may be a main reason for Fed to taper.

Is Fed tapering too early? I don't think so. US economy has shaken off recession since 2010, growth firming since late 2011. Jobless Claims are back to healthy levels. Though overall growth is still sub-optimal, the deeper solution is productivity gain, mgt excellence and technological advancement, not monetary stimulus. US has been doing well in its Natural Gas, Biotech and Tech space in recent 3 years. Also Fed had a long paper in the Greenspan time discussing the Japanese lesson. That paper concluded that too early policy retreat was the main reason on why the Japanese recession had lasted so long. And later repair to inject again could not neutralize the too early retreat damage. So Bernake being a recession expert, don't think he would repeat Fed's conclusion on Jap mistake.

Where is Tsy heading? I do not think the recent impulsive rocket to repeat as bond being a relatively rational mkt, though some of that character is being diffused after QE. I tend to think a gradual bottom building between 2.5% - 3.5% in the next 12 months of Fed tapering. Dow should perform well if that's the case. Let's see.

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