TheStar
SELLING pressure pushed the Malaysian Government Securities (MGS) yield curve up by between five to 11 basis points (bps) in the last week.
Over the short to medium term, the shape of the MGS yield curve will be determined by three factors:
Movement of the ringgit
US dollar/ringgit reached 3.131 on April 23, the lowest since it was de-pegged in July 2005. Foreign investors have been actively trading in the MGS market since the de-pegging to take advantage of the ringgit appreciation.
However, the ringgit rise against the greenback has hit some resistance since April 23. Year-to-date, it has advanced only 1.9%, compared with 6.7% and 7.1% appreciation in 2007 and 2006 respectively.
We expect the ringgit to trade within the 3.20-3.25 range in the next three months.
One of the reasons for this is the expectations that the US will stop cutting the Fed Funds rate further and may instead reverse its course to counter rising inflation.
Second, domestic political uncertainties post-election are still unresolved, and this could cause foreign investors to be sidelined while awaiting the uncertainties to play out.
Furthermore, we note that since the ringgit was “floated”, it tends to rally in the first and fourth quarters of the year, and weaken in the second and third quarters.
We believe such “seasonalities” would also limit the ringgit upside between now and year-end, thus maintain our outlook of US dollar/ringgit reaching 3.10 by year-end.
Given their risk aversion, foreign investors tend to invest in the shorter-end of the yield curve.
We have previously noted that they are very active in the bills market and also up to the 3-year segment of the MGS curve. However, due to the softer ringgit of late, they have concentrated mostly in the bills market.
The 3-month Malaysian T-bill has been hovering between 3.25% and 3.50%, lower than the overnight policy rate (OPR), signifying good demand in this segment.
On the other hand, the three-year MGS has risen by 11 bps to 3.62% over the last week on concerns of higher future inflation.
Given our view that the ringgit will be soft and range-bound and that the OPR will be steady in the next three months, we expect the three-month T-bill to continue to linger at 3.25%-3.50%, while inflationary pressures will push the three-year yield upwards.
However, we do not expect the three-year yield to rise much, as most local fund managers are still awash with cash and will look to support the security when yields rise.
Expectations of future inflation rate
Rising oil prices have increased fuel subsidies beyond the Government’s budget levels. As such, the Second Finance Minister Tan Sri Nor Mohamed Yakcop said the Government would unveil a fuel subsidy reform plan before the 2009 Budget is tabled on Aug 29.
The reform, which is expected to benefit the low- and middle-income groups, will increase the country’s inflation rate, going forward.
In fact, expectations of higher future inflation have made the MGS yield curve steeper in the last month, with the 3/10 spread increasing by about 13 bps during that period.
Inflation erodes the purchasing power of bonds' fixed interest payments. In an environment where inflation is expected to rise, investors would demand a larger coupon from newly issued bonds, or a higher yield for any existing bonds.
As such, we expect the 3/10 segment of the yield curve to continue its bear-steepening stance in the next three months.
Bear steepening is a case where the long-end of the curve moves up relative to the short-end of the curve, as opposed to a bull steepening where the short-end of the curve moves down relative to the long-end of the curve.
Supply and demand factors
The 10/20 segment of the curve is also expected to rise in tandem with the 3/10 segment.
However, we do not expect the 10/20 spread to widen significantly, despite an environment of higher inflation.
This is caused by the supply and demand for the 20-year bond. The amount outstanding for the current 20-year MX5/27 is only RM6bil.
Meanwhile, the auction for the new 20-year MGS is scheduled only in September 2008. Despite the low supply of the 20s, demand for the long bond is high, especially among insurance companies.
The interplay between supply and demand for the 20-year bond and inflation will cause the 10/20 spread to widen slightly over the next three months.
At the same time, we expect some form of parallel upward shift in this segment to mirror the expected steepening in the 3/10 segment.
In conclusion, we expect the T-bill segment of the curve to remain rather stagnant with slight upward bias over the next three months, while the 3/10 segment to experience a form of bear steepening.
At the same time, the 10/20 segment is expected to experience some sort of parallel upward shift, and a slight form of bear steepening.
Under the circumstances, short-term traders should invest in shorter duration bonds, targeting the three-year and below segment.
Insurance companies, due to the nature of their businesses, should pick the 10- and 20-year bonds, at levels that they are comfortable at, as their yield rises.
Disclaimer: Reading materials in this site are obtained from its respective website and it is for information purposes only. It is not Malaysia Unit Trusts - administrator view and it is not to be used against Malaysia Unit Trusts - administrator.
