The effectiveness of conventional monetary policy has reached certain constraints. We have observed these constraints through the use of new policy tools like yield curve control in Australia, the new inflation targeting framework in the US, new market liquidity support mechanisms and the tepid response by bonds during March 2020 in Europe and Japan.
The chart below shows the effect of the zero lower bound during February and March, 2020. German and Japanese bonds did not have scope to move materially lower (prices higher) to offset the large equity drawdown being experienced. US bonds did have more room to move lower and these were critical to the protection we achieved in Q1 2020 (-1.8% Q1 return, 7.9% 2020).
In Australia, as a response to the pandemic, the RBA extended the duration of its policy guidance and embedded this into a 3 year yield curve target. Since then they have successfully defended this target but are actively considering whether this will be extended. One of the effects of this policy is to reduce the price signals within movements of the bond yield curve and reduce the effectiveness of short dated Australian bonds as a portfolio diversifier. We also think this increases tail risk for the curve from changes in monetary policy.
We have now designed, tested and implemented a new strategy which incorporates longer dated Australian bond yields. Testing incorporated more than 20 years data but with a particular focus on the conditions since March 2020 and the scenarios going forward. We believe the new strategy will be more responsive, has scope for more diversification and also for shorting if yields rise persistently.
Research also continues on a new global long bond relative value strategy, a long equity volatility strategy and greater utilisation of short A$ currency for tail hedging.
Source: Darling Macro For wholesale investors only.
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