Frank Uhlenbruch, Investment Strategist in the Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
The strong performance of global bond markets continued over July, with returns boosted from a further decline in yields and narrowing in credit margins. The search for yield continued to underpin exceptionally strong demand for credit investments, with bid to cover ratios for primary issuance at extremely elevated levels. Domestically, the Reserve Bank of Australia (RBA) followed up June’s rate cut with another 25 basis point (bps) cut, taking the official cash rate down to 1%. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.95%, with price appreciation from lower yield and tighter spreads boosting the income return.
Following the widely expected move by the RBA and better than expected US inflation data, three and 10 year Australian government bond yields rose to as high as 1% and 1.45% mid-month. Yields subsequently rallied as offshore central banks became increasingly dovish with the US Federal Reserve (Fed) cutting the Fed funds rate by 0.25% at the end of the month. The rally over the second half of the month saw three and 10 year Australian government bonds end the month 15bps and 14bps lower, hitting historical lows of 0.82% and 1.18%, respectively.
Money market yields reacted to the RBA move and offshore developments by discounting further monetary easing. Three and six month bank bill yields fell by 20bps and 19bps to end the month at 1.01% and 1.03%, respectively. Markets are now fully pricing in a 0.75% cash rate by November 2019 and a 0.5% cash rate mid-2020.
Credit markets ended slightly stronger, with the iTraxx Index closing 4bps tighter at 59bps. During the month, APRA finalised its approach to loss absorbing capacity for the domestic major banks and announced that an additional 3% of capital was required and this was to be funded via existing capital instruments. Major banks subsequently announced their intention to meet this requirement by issuing subordinated bonds. Westpac and ANZ hit the ground running with large deals in the USD and AUD markets, respectively. This additional issuance of subordinated debt means a lower supply of senior unsecured bonds over time and this dynamic saw the credit spreads of these securities rally meaningfully over the month.
Economic data readings were on the sluggish side, with retail sales lifting by only 0.1% in May. Despite RBA rate cuts and the prospect of near-term tax breaks, consumer sentiment fell in July. According to the NAB survey, there was a modest lift in business conditions though these remain slightly below longer run levels.
Labour market conditions cooled, with total employment lifting by 500 jobs. The composition of this gain was on the encouraging side however, with full time jobs up by 21,100 and part time jobs down by 20,600. The participation rate remained at a historically high level of 66%. The employment component of the June NAB survey is consistent with near-term job gains of around 20,000 per month, which should be sufficient to keep the unemployment rate at or slightly below current levels.
On the prices side of the economy, the headline inflation rate lifted by a stronger than expect 0.6% over the March quarter, lifting the yearly rate from 1.3% to 1.6%. Underlying inflation remains subdued, with the average of the RBA’s statistical measures lifting by 0.4%, for a yearly rate of 1.4%.
Offshore central banks and Chinese policy makers appear to be responding to the current configuration of subdued inflation and trade and Brexit uncertainty by signalling moves towards more accommodative policy stances.
In Europe, Mario Draghi, the European Central Bank President, expressed dissatisfaction with the growth and inflation outlook and raised market expectations for an easing package at its September meeting. In China, the Politburo noted that downside risks had increased and the need to keep liquidity appropriate and abundant. They ruled out using property as a short term stimulus, preferring to support demand via reforms to expand consumption. In the US, the Fed delivered a precautionary 25bps cut in the Fed funds rate, casting the move more in a risk management light rather than as the start of an extended easing cycle.
Against this backdrop, the RBA cut the cash rate by 25bps in both June and July noting that these moves would make further inroads into spare capacity and assist with faster and more assured progress towards its inflation target.
We initially thought the RBA would pause while it waited to see how the economy would respond to:
- 50bps of easing (cash rate cut from 1.5% to 1%);
- the first tranche of tax relief worth 0.5% of GDP (similar impact to two rate cuts);
- bringing forward of smaller ‘shovel-ready’ infrastructure projects;
- relaxation in macro prudential policies related to residential lending;
- a potential rebound in consumer sentiment associated with a plateau/lift in house prices;
- a 3% lift in the minimum wage (up around 10% over the last 3 years); and
- the removal of pre-election policy uncertainty.
However, we have modified our base case forecasts following the RBA Governor’s speech on ‘Inflation Targeting and Economic Welfare’. In that speech, the Governor noted that while Australia’s fundamentals were strong and that complementary policy measures should boost demand, the RBA stood ready to provide additional policy support if needed. Even if easing was not required, the Governor stated that it was “reasonable to expect an extended period of low interest rates” and that rates would not move up until the RBA were confident that inflation would return to around the midpoint of its target range.
We now look for a further cut in the cash rate before the end of the year and have pushed back the timing of the first tightening into 2022. We see the balance of risks tilted to the low side in the near-term and agree with the Governor that fiscal policy, not monetary policy, is best suited to dealing with any significant demand shocks.
Accordingly, we see three year Australian government bond yields at around 82bps at the time of writing as being towards the expensive end of our fair value band. Even after allowing for our lower cash rate projections and downward revisions to our longer term neutral cash rate estimates, we struggle to see any value in long term yields at prevailing levels. Term premia remain extraordinarily depressed and break-even inflation rates very low for an open economy with a floating exchange rate and accommodative policy settings. More broadly, if monetary policy cannot boost demand from here, there is the risk that unconventional and untried measures may be used here or offshore and bring with them the risk of higher inflation in the future. Views as at 31 July 2019.
Australian government bond yields continued to rally as the Reserve Bank of Australia (RBA) cut the cash rate and major offshore central banks signalled more policy support to provide an offset to ongoing trade tensions if needed. Sentiment shifted from ‘risk-off’ to ‘risk-on’, with equity markets performing strongly and credit spreads narrowing as investor searched for yield. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.04%, with price appreciation from lower yields boosting the income return.
After laying the ground work for monetary easing on the view that the economy had spare capacity, the RBA followed up by cutting the cash rate from 1.5% to 1.25% early in the month. The previous burst of easing was a 50 basis point (bps) move between May and August 2016. Following the move, the RBA Governor noted that the decision was about making further inroads into the spare capacity in the economy and assisting with “faster progress in reducing unemployment and achieving more assured progress towards the inflation target”. Subsequent commentary was consistent with a near-term follow up move.
Against this backdrop and dovish commentary from the US Federal Reserve (Fed) and the European Central Bank (ECB), three and 10 year government bond yields both ended the month 14bps lower at 0.96% and 1.32%, respectively.
Money market yields reacted to the RBA move by bringing forward the timing of the next cut to August with a high chance of a July move. Three and six month bank bill yields fell by 21bps and 20bps to end the month at 1.21% and 1.22%, respectively. Markets are now fully pricing in a 0.75% cash rate by February 2020 and assigning around 70% chance of a 0.5% cash rate mid-2020.
The Australian economy put in a third quarter in a row of sub-trend growth, recording growth of only 0.4% over the March quarter and 1.8% over a year ago. Dwelling investment and stocks detracted from growth. Consumption, business investment, the public sector and net exports made small positive contributions.
While output measures remain subdued, labour conditions continue to hold up. Employment rose by a stronger than expected 42,300 over May but a lift in the participation rate to a record high of 66% meant that the unemployment rate remained unchanged at 5.2%. This rate remains well above the RBA’s 4.5% long-run sustainable rate, and indicative of further slack.
Forward labour market indicators point to a moderation in labour demand, with the May NAB Business Survey consistent with employment growth of around 18,000 per month, a rate consistent with mild improvement in the unemployment rate.
There was early evidence of a possible lift in activity post the Coalitions unexpected election win, with the preliminary June CBA Manufacturing and Services PMIs lifting further into expansion territory. Business conditions in the earlier May NAB Business Survey were more subdued with cost pressures weighing on profitability.
The ‘risk-on’ sentiment seen in global markets extended to the domestic credit market with the iTraxx Index finishing June 15bps tighter, at a spread of 63bps. Credit investors reacted positively to the signal of further monetary stimulus from the Fed and ECB, as well as the reduction in official interest rates by the RBA. Primary market activity however, was relatively subdued. One notable highlight was the ANZ bank that issued a new RMBS security. The $1.5bn deal was the first RMBS bond issued by the company since late 2016 and was met with strong demand.
While major global central banks have responded to the uncertainty created by trade tensions by signalling further policy accommodation, the latest move by the RBA primarily reflected more domestic concerns.
These centred on cumulative evidence that the economy still had some spare capacity. In the words of the RBA Governor, the cut in the cash rate from 1.5% to 1.25% in early June was “not in response to a deterioration in the economic outlook”…but “reflected a judgement that we could do better than the path we looked to be on”.
We look for another rate cut in July/August and thereafter expect a period of stability as the RBA waits to see how the economy responds to:
- 50bps of easing (cash rate cut from 1.5% to 1%);
- the first tranche of tax relief worth 0.5% of GDP (similar impact to two rate cuts);
- bringing forward of smaller shovel ready infrastructure projects;
- a potential rebound in consumer sentiment associated with a plateau in house prices;
- relaxation in macro prudential policies related to residential lending;
- a 3% lift in the minimum wage (up around 10% over the last 3 years); and
- removal of pre-election policy uncertainty.
While less controllable, a return to more seasonal conditions would also provide a boost to the economy, as would prolonged weakness in the exchange rate.
Although another easing is possible late this year or early next year, it would need the economy to not respond to considerable stimulus and would also need to pass the RBA’s welfare test. A move below 1% may disproportionately hurt savers, lead to a surge in borrowing and increase the risk of capital being misallocated as investors search for higher yielding alternatives. It is on this basis that we anticipate growing resistance to the cash rate moving too far below 1.0%. As the RBA Governor has reiterated, fiscal policy is far better equipped to support aggregate demand at this juncture.
We see the shorter end of the curve, where markets are assigning a 70% probability to a 0.50% cash rate mid-2020 being moderately expensive, and assigning little probability to the economy responding to the complementary policy push it is receiving. We think there is reasonable scope for markets to reassess the amount of easing needed over the second half of the year, which if this were to eventuate, would lead to a modest increase in shorter-term bond yields.
Long-term yields look increasingly over-valued on a range of valuation metrics that we use. Real yields, term premium and break-even inflation rates are around historic lows. A key aspect of our investment approach is that markets are prone to overshoot fundamental value as temporary influences are disproportionately reflected in the valuation of long-term securities. While this only ever becomes evident in hindsight, we feel the current environment is displaying characteristics of this. We do not discount the possibility of yields moving even lower but beyond the short term anticipate a meaningful lift in longer-term yields as policy initiatives foster an improvement in growth and a lift in actual and expected of inflation. Views as at 30 June 2019.
Australian government bond yields continued to rally as markets moved to price in near-term monetary easing. The longer end of the curve benefitted from flight-to-quality flows as trade tensions flared and expanded to include US/Mexico relations. Sentiment shifted from ‘risk-on’ to ‘risk-off’, with equity markets falling heavily and credit spreads widening. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.7%, with price appreciation from lower yields boosting the income return.
Three and 10 year government bond yields drifted lower in the lead up to a speech by the Reserve Bank of Australia (RBA) Governor on the outlook for the economy and monetary policy. In that speech the Governor signalled that the RBA would consider the case for lower interest rates at its June meeting. Yields subsequently rallied, with the long end boosted late in the month by the US decision to apply tariffs on Mexico. Three and 10 year government bond yields ended the month 18 and 33 basis points (bps) lower at 1.10% and 1.46% respectively.
Money market yields reacted to the RBA signalling by bringing forward the timing of the first easing to June. Three and six month bank bill yields fell by 14bps and 21bps to end the month at 1.42% and 1.41%. Markets are now fully pricing in a second easing by September and assigning around a 75% chance of a 0.75% cash rate by May 2020.
On the political side, the Coalition government defied the polls and retained government. From an economic perspective, partial demand indicators point towards another quarter of sub-trend growth in the upcoming March quarter national accounts. While net exports are poised to add to growth, a 0.1% fall in Q1 real retail sales suggest that consumption remains weak.
The labour market appears solid but forward indicators point to some moderation. Jobs rose by a stronger than expected 28,400 in April, with the participation rate climbing to a cyclically high 65.8%. However, as not all new entrants were able to find employment, the unemployment rate rose from 5.0% to 5.2%. A lift in the underutilisation rate from 13.3% to 13.7% suggests that there is still spare capacity despite 322,900 people finding employment over the last year.
Forward labour market indicators point to a moderation in labour demand, with the April NAB Business Survey consistent with employment growth of around 14,000 per month, a rate which will make it difficult for the unemployment rate to fall further. Wages growth remains moderate, with the March quarter Wage Price Index gaining 0.5% for an unchanged yearly rate of 2.3%. The Fair Work Commission announced a 3% lift in the minimum wage, down from 3.5% the previous year, but well above the prevailing rate of wages growth.
Credit markets were not immune from the ‘risk-off’ sentiment experienced in other markets, with the Australian iTraxx Index widening 13bps and finishing May at a spread of 79bps. The return of the Coalition government, as well as APRA announcing some potential easing of lending restrictions, had a muted impact on major bank credit spreads, but hybrid securities benefitted from the removal of the possible changes to franking credits. Primary markets were quiet compared to the previous month, but the one highlight was NAB issuing $1bn of new subordinated bonds at a credit spread of 215bps.
Following the RBA Governor’s speech, we brought forward the timing of our two rate cuts and now look for the RBA to move at its June and August meetings. It appears as though the economy (which has slowed from above trend growth rates in the first half of 2018 to below trend rates from mid-2018 onwards) is about to get a complementary policy boost made up of:
- 50bps of monetary easing;
- a relaxation in macro prudential settings;
- tax cuts worth around 0.5% of GDP (similar impact to two rate cuts); and
- a 3% boost to the minimum wage following the latest Fair Work Commission decision.
These in aggregate provide a near term pro-cyclical pulse that should help underpin activity at a time when the housing sector is cooling. We see some merit in the RBA pausing after a June move to give it time to assess whether some of the more recent slowing had a ‘deferral component’ as economic agents waited to see the outcome of the election. It appears as though activity levels have picked up in key property markets and stabilisation in house prices would see an end to the negative wealth and confidence effects from falling house prices.
By bringing easing forward, the RBA have reduced the risk of having to ease more later. The growth outlook over the second half of 2019 should also benefit from a return to normal seasonal conditions and the end of the drag to growth from the completion of large LNG projects.
While we see the near-term risks tilted to the low side given current trade tensions, markets largely pricing in 75bps of easing by mid-2020 takes the shorter end of the curve to being fully-priced in our view and susceptible to any post-election pick-up in sentiment/activity and ‘less pessimistic’ RBA signalling. That said, with the end of the current easing cycle still a long way off, the scope for a material sell-off at the shorter end is limited.
Further out along the yield curve, we see the yield on a 10 year government bond of 1.49% (at the time of writing) as being modestly expensive, pricing in low terminal rates by historical standards and offering investors little reward for taking on term risk. Views as at 31 May 2019.
Australian government bond yields rallied at the shorter end of the yield curve as markets continued to bring forward the timing of monetary easing. Yields at the longer end of the curve gave back earlier gains to end the month largely unchanged. Supportive policy settings and signs that the deceleration in global and domestic growth evident late 2018 had passed helped support risk appetite. Equity markets were firmer and there was further tightening in credit spreads. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.28%, primarily reflecting the income return.
Partial demand indicators improved over the month, with three and 10 year government bond yields lifting to as high as 1.49% and 1.96% before the release of the March quarter Consumer Price Index (CPI) towards the end of the month. Building approvals and retail trade data for February came in well-ahead of expectations, with approvals up 19.1% over the month and retail trade up 0.8%. According to the NAB Survey, business conditions lifted from below trend to around trend levels in March.
The Federal Budget and prospect of further fiscal easing in the upcoming Federal election helped lift consumer sentiment in April back towards longer run levels. The run of strong trade data continued, with the trade surplus lifting from $4.3bn in January to $4.5bn in February. These data are consistent with a pick-up in the pace of growth from the weak levels prevailing over the second half of 2018.
Labour market conditions remained solid. Employment grew by a stronger than expected 25,700 in March, with the number of full time jobs surging by 48,300. Part time jobs fell by 22,600 and a slight lift in the participation rate back towards cyclical highs meant that the unemployment rate edged back up to 5%. Forward labour demand indicators are mixed, but still consistent with job gains sufficient to hold the unemployment rate steady to slightly lower.
It was the release of weaker than expected consumer price data that triggered a late month rally and saw markets bring forward the timing of the first easing. While a low headline rate was expected because of earlier falls in fuel prices, the 0.2% lift in the average of the Reserve Bank of Australia’s (RBA) statistical or core measures was well-below expectations. The yearly core rate slipped from 1.7% to 1.4% and triggered one of the RBA conditions for easing, the other being sustained weakening in the labour market.
Yields rallied from mid-month highs following the CPI release and markets went as far as pricing in around a 50% chance of a rate cut in May. The three year government bond yield ended the month 11 basis points (bps) lower at 1.28% while the 10 year government bond yield closed 1bps higher at 1.79%.
Money market yields reflected the bringing forward of easing expectations, with three and six month bank bill yields falling by 21bps and 22bps to end the month at 1.56% and 1.62%. Markets are fully pricing in an easing in July with a 1% cash rate priced in by November. By mid-2020, markets are assigning around a 20% chance of a 0.75% cash rate.
Credit benefitted from the ‘risk-on’ tone this month as investors searched for yield in an environment where inflation is sluggish and central banks are looking to maintain or increase accommodative policy settings. The iTraxx Index tightened 9bps to close at 66bps which is towards the lower end of historical outcomes. The highlight in primary markets was Woolworths issuing the world’s first green bond by a supermarket retailer. The demand for this bond by domestic investors was significant, with the company printing $400m of new bonds to around $2bn of investor demand.
We see information in the March quarter CPI release that justifies a shift in our base view from a ‘steady for longer’ scenario for the cash rate to one where the RBA needs to provide the economy with a further burst of easing on top of a 0.5% of GDP boost coming from tax cuts starting from the beginning of July.
While in the latest set of minutes the RBA noted that it was not possible to fine-tune outcomes and that by holding policy steady it would be a source of stability and confidence, they also noted that in a scenario where inflation did not move higher and the unemployment rate trended up it would be appropriate to ease in those circumstances.
We see the weak 0.3% lift in non-tradeables inflation and fall in the yearly rate from 2.4% to 1.8% as indicative of a combination of remaining slack in the economy and competitive pressures. The RBA will have to revise its inflation outlook lower in its upcoming May Statement on Monetary Policy and balance a situation where one of its two preconditions for easing has been triggered.
We suspect that the RBA will move to an explicit easing bias in May but will have cut the cash rate to 1% by November, judging that it would be in the public interest to ensure that inflation returned to the target band and that inflation expectations did not become unanchored.
Our view is that while monetary conditions are already accommodative, the combination of a further burst of monetary easing, easier fiscal conditions and possibly a lower exchange rate, will help support activity and speed up the rate of absorption of spare capacity. While markets see the prospect of further easing in 2020, we suspect that 1% will be the low in the cash rate and that the RBA, like the US Federal Reserve, will seek to normalise the cash rate as soon as conditions allow.
We currently see three year government bond yields at 1.27% (at the time of writing) as being towards the expensive end of our fair value range. There is scope for a nearer term lift if markets wind back the amount of easing currently priced in, but the prospect for any significant rise is limited given that there is still slack in the economy. Further out along the yield curve, we see the yield on a 10 year government bond of 1.78% (at the time of writing) as being modestly expensive and vulnerable to any upward revision to global growth or inflation expectations.
Views as at 30 April 2019.
Australian government bond yields rallied to historical lows as confidence in the durability of the global and domestic economic expansion waned and market expectations for another burst of monetary easing strengthened. Supportive central bank actions, along with steps taken by Chinese policy makers to bolster the growth outlook, helped support risk appetite. Equity markets were generally firmer and there was some further tightening in credit spreads. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, had an exceptionally strong month, gaining 1.8% with price appreciation from lower yields boosting the income return.
The key data release to catch the market’s attention and help bring forward monetary easing expectations was softer than expected economic growth in the December quarter. Sluggish consumption fuelled concerns that the slowing in the household sector over the second half of 2018 could be of a more permanent nature, rather than just a cyclical event. The economy grew by only 0.2% over the December quarter, with the yearly rate slowing to a below-trend 2.3%.
While patchy, partial demand indicators for the March quarter point to a modest pick-up in the rate of growth from the low levels experienced late last year. The trade balance moved further into surplus over January, while building approvals lifted 2.5%. Business surveys continue to paint a picture of a move from above trend levels over the first half of 2018 to around trend levels.
Consumption started the quarter on a soft note, with retail sales lifting by a less than expected 0.1% in January. Consumer sentiment, which recovered strongly in February, gave those gains back in March following poor headlines associated with the weaker GDP print. Wealth effects were mixed, with the rate of house price falls moderating while the total return from the S&P/ASX 300 Index was 10.9% over the March quarter.
In contrast to moderating activity based measures, labour market conditions appear to be holding up. The unemployment rate fell from 5.0% to 4.9% in February, though the rate of job gains eased from 38,300 in January to 4,600 in February. Unlike the previous month, part time jobs were stronger, lifting by 11,900, while full time jobs fell by 7,300 following a booming gain of 65,600 in January. Jobs vacancies rose by 1.4% over the three months ending in February, down slightly from November’s 1.6% gain. Forward labour demand indicators have eased, but are still consistent with job gains sufficient to hold the unemployment rate steady to slightly lower.
Against this softer global and domestic backdrop, three and 10 year government bond yields ended the month 24 basis points (bps) and 32bps lower at historically low yields of 1.39% and 1.78%. After outperforming US treasuries over February, the move lower in Australian government yields was similar to those in the US where two and 10 year treasuries ended the month 25bps and 31bps lower, at 2.26% and 2.41%.
Money market yields continued to ease as markets both brought forward the timing of the first easing from February 2020 to August 2019 and moved to price further easing, assigning a 90% chance of a cut in the Reserve Bank of Australia (RBA) cash rate to 1% by May 2020. Three and six month bank bills ended the month 10bps and 16bps lower at 1.77% and 1.84%.
Credit markets had a quiet month, with credit spreads largely range-bound and slightly tighter compared to a month earlier. While primary market activity was lower, there were some notable transactions from companies rated in the BBB area. The theme of domestic investors favouring infrastructure assets continued, with ConnectEast (rated BBB), the owner of the East Link toll road concession, issuing $250m of bonds with a seven year maturity and they garnered around $1bn worth of demand. Incitec Pivot, also rated BBB, managed to issue $450m of new bonds, with a seven year maturity to strong investor demand.
The RBA policy path has become more uncertain, with the RBA’s Luci Ellis, Assistant Governor (Economic), noting in a recent speech that “outside the household sector, the economy is not doing too badly”. In a deep-dive into the household sector, she noted that slow income growth was a drag on household spending and there was a risk that consumers would see lower incomes as permanent and adjust their consumption lower.
A key driver of recent weakness in household disposable incomes and offsetting modest improvement in labour income has been a sharp lift in the tax-to-income ratio. The consumers’ loss has been the Government’s gain, with the Budget position improving faster than expected. Fiscal, not monetary policy, is best equipped to deal with this drag on household incomes.
Fiscal easing, combining tax cuts skewed towards low to middle income earners and increased government spending is on cards as both major parties make their pre-election pitches. With an election likely to be called in the first half of May, we expect the RBA to factor in changes in the fiscal stance in its monetary policy deliberations.
While the market has largely factored in two 25bps cuts to the cash rate, whether we get these will depend on how the output/employment gap that has opened up resolves itself. In the RBA’s view, monetary policy is currently accommodative and their base case view calls for further labour market tightening that gradually lifts wages and inflation. There are signs that this is happening on the wages front, but progress is slower than the RBA would like.
With labour demand holding up at the margin, there does not appear to be a near term case for any easing, though the RBA may use the May Statement of Monetary Policy to trim its growth and inflation forecasts and potentially signal an easing bias.
Our base case has the RBA on hold out to 2021 against the backdrop of fiscal easing, a manageable correction in the housing sector and a global economy responding to easier policy settings and a likely mid-year trade deal between the US and China.
We see the balance of risks tilted to the downside, with inversion in the US yield flashing a warning light about future US and world growth. Domestically, monetary policy may have to be eased further to reinforce easier fiscal policy if there is a negative global shock or the output /employment gap is resolved by labour market weakening.
We currently see three year government bond yields at 1.41% (at the time of writing) as being in our fair value range. The scope for any significant lift is limited given that the outlook for the path of the cash rate over the next couple of years is steady to lower. Further out along the yield curve, we see the yield on a 10 year government bond of 1.79% (at the time of writing) as being expensive and would need a global recession and significant downgrading of Australia’s neutral cash rate to justify current valuations.
Views as at 31 March 2019.
The rally in Australian government bond yields continued as markets bought forward easing expectations following a shift in the Reserve Bank of Australia’s (RBA) forward guidance and patchy domestic economic readings. Risk appetite continued to recover following supportive central bank actions around the globe, with equity markets performing strongly and further narrowing in credit spreads. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.94% over February, with price appreciation from lower yields boosting the income return.
On the data front, readings from the interest rate sensitive sectors of the economy were on the weaker side. Building approvals fell by a greater than expected 8.4% in December and followed a 9.8% fall in November. After rising 0.5% in November, retail sales for December fell 0.4% with real retail sales up only 0.1% for the December quarter, pointing to weak consumption growth in the upcoming national accounts. Consumer sentiment, which fell sharply in January, rebounded in February with improvement in a range of forward-looking spending indicators.
There was a moderate rebound in business conditions in the January NAB Business survey after December’s sharp falls and though the overall level remains above long run levels, conditions remain well below those that prevailed over the last two years. Private capital expenditure rose a stronger than expected 2% in real terms over the December quarter and there was an 11% increase in the first estimate of 2019/20 expenditure levels compared to the first estimate for 2018/19.
In contrast to activity-based measures, labour market conditions remain strong. Employment rose 39,100 in January, with full time jobs surging by 65,400, while part time jobs fell by 26,300. Labour force participation rose back towards cyclical highs, while the unemployment rate remained unchanged at 5%. Forward employment indicators point to monthly jobs gains sufficient to keep the unemployment rate at around 5% or slightly lower.
There were further tentative signs that labour market tightening was translating into higher wages, with both the private and public sector wage price index lifting by 0.6% over the December quarter. The private sector wage price index was up 2.3% over a year ago, a growth rate not seen since 2014.
Against this mixed back drop, three and 10 year government bond yields ended the month 12 basis points (bps) and 14bps lower at 1.63% and 2.10%. Australian government yields continued to outperform those in the US, where the US two and 10 year treasury ended the month 6bps and 9bps higher, at 2.51% and 2.72%. The spread between US and Australian 10 year government bonds ended the month at an unusually wide -62bps and is reflective of different monetary and fiscal outlooks.
Money market yields eased on improving liquidity conditions and a bringing forward of easing expectations. Three and six month bank bills ended the month 20bps and 19bps lower at 1.87% and 2.00%. Markets not only became more convinced that the next move in the cash rate would be down, they also brought forward the timing of any prospective cuts. At the end of February, markets were pricing in around a 50% chance of a rate cut in August and around a 75% chance of a cut in November. By February 2020, markets are fully pricing in a rate cut.
February marked the bi-annual reporting season for corporate Australia, with an overall positive reporting period and credit profiles remaining sound. This, along with positive offshore sentiment, pushed the iTraxx Index 8bps tighter to finish the month at 69bps. The conclusion of the reporting period provided the green light for companies to tap the local bond market. From a primary market perspective, highlights were debut Australian dollar deals from two American based global businesses – General Motors and McDonald’s, with the latter pricing a three tranche (5/7/10 year maturity) bond deal raising $1.4bn in total.
The RBA joined other central banks in signalling a shift to a more supportive policy stance following the loss of economic momentum and confidence late last year. In the US, the Federal Reserve (Fed) changed its forward guidance from further tightening to monetary policy being on hold. The RBA changed its forward guidance from a tightening bias to neutral bias with balanced upside and downside risks. In China, the focus of policy has shifted more towards stabilising growth rather than focusing on financial risks.
The RBA Governor recently outlined that the RBA’s strategy to meet its mandated objectives was to keep monetary policy accommodative until a tightening labour market led to a lift in wages and inflation. In comments made to the House of Representatives Standing Committee on Economics, the Governor noted that progress was being made on this front but it was occurring at a slower rate than he would like.
The Governor also characterised the downgrade to their growth and inflation forecasts as the RBA not becoming bearish, but rather that the outlook “remained positive, just not as positive” as when they released their last projections in November. The outlook for consumption was a key source of uncertainty given recent low real wages growth and negative wealth effects from falling house prices.
Our base case view is that the RBA remains on hold until late 2020/early 2021, before gradually winding back the amount of monetary policy accommodation. Such a view allows for a sharp fall in dwelling investment as the amount of building falls back to longer run levels, but the drag from this is offset by strong public sector demand and a recovery in business investment. Housing prices should find a floor towards the end of the year as lower prices improve affordability and household formation. A stabilisation in housing prices removes the drag from negative wealth effects on the consumption outlook.
We see the risks to our base case view as tilted to the downside and would need to see signs of sustained labour market weakening before shifting our base case view. Unlike current market pricing for just one easing, we would expect that in such a scenario the RBA would ease by 50bps, rather than by the 25bps of easing currently priced in.
We currently see three year government bond yields at 1.66% (at the time of writing) as being mildly expensive with risks of significant sell-off low given that we have yet to weather a period of falling housing construction. The longer end of the curve looks expensive factoring in a very low terminal cash rate and is vulnerable to any upward reassessment of global growth and inflation prospects following recent weakness.
Views as at 28 February 2019.
Australian government bond yields continued to rally over January as weaker domestic economic readings led markets to become more confident that the next move in the cash rate would be down. Longer-dated yields benefitted from flight-to-quality flows when concerns over trade, Brexit and the US government shutdown were most elevated. Risk appetite recovered, with equity markets performing strongly and there was some narrowing in credit spreads. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.64% over January and follows December’s strong gain of 1.5%.
The domestic economy looks to have lost some momentum towards the end of 2018 and confidence measures, which had held up through an earlier period of falling house prices and equity markets, fell sharply in December. On the activity side, there was a sharp fall in the business conditions index in the NAB survey from well above, to well below long run levels. While most likely reflecting some seasonal volatility, given that other PMI measures remained in expansion territory and capacity utilisation rates in the NAB survey were elevated, future moves in this series bear close monitoring. Building approvals declined a greater than expected 9.1% over November, to be down 33% from the peak levels of a year ago.
Labour market conditions remained solid, with the unemployment rate falling back to 5% in December and total jobs lifting by 21,600. The composition of jobs gains was on the softer side, with full time jobs falling by 3,000 while part time jobs rose by 24,600. The participation rate slipped from 65.7% to 65.6%, but still remains close to cyclical highs. Forward labour market indicators were mixed with DEWR skilled vacancies lifting 0.7% in December, while the NAB employment index pointed to a fall in near term jobs growth from around a 22,000 per month pace to an 18,000 per month pace.
The rate of credit growth continued to slow in December, reflecting a combination of demand and supply side factors with the slowdown most evident in personal and investor lending. On the prices side, headline inflation rose a stronger than expected 0.5% over the December quarter for a yearly rate of 1.8%. Core inflation remains contained, with the average of the Reserve Bank of Australia (RBA) statistical measures lifting by 0.4% for a 1.8% year rate. The income side of the economy should receive a boost from a jump in the terms of trade, with the export price index lifting by 4.4% over the December quarter against a 0.5% lift in the import price index.
Against this back drop, three and 10 year government bond yields ended the month 10 basis points (bps) and 8bps lower at 1.75% and 2.24%. Australian government yields outperformed those in the US, where the US two and 10 year treasury ended the month 3bps and 5bps lower, at 2.46% and 2.63%, following the eventual reopening of the US government and the US Federal Reserve (Fed) signalling that monetary policy was on hold.
In money markets there was a modest easing in the tightening of liquidity conditions experienced at the end of last year. Three and six month bank bills ended the month 2bps and 4bps lower at 2.07% and 2.19%. Markets became more convinced that the next move in the cash rate would be down, moving from pricing in a 36% to around 50% chance of an easing by the end of the year. For May 2020, the market shifted from pricing a 40% to a 70% chance of a rate cut.
Credit markets strengthened as risk appetite recovered, with the iTraxx Index tightening 18bps to close at 77bps. After an extremely quiet December, primary markets re-opened and this was led by the major banks. Between CBA, ANZ and Westpac, they raised just under $12.5bn from domestic investors over the month. Given the impending release of the Royal Commission findings, this was a strong result for the banks. The domestic company reporting season occurs in February and this will provide investors with an update as to how companies are managing their credit profiles.
Despite comments from an RBA board member that the next move in the cash rate was eventually up, the gap between the RBA’s expectation for the path of the cash rate and market pricing continued to widen in January.
Given recent choppiness in domestic data, unresolved trade tensions and a slowing in the global economy, we expect that the RBA will signal in upcoming communications that leaving the cash rate unchanged at current accommodative levels will help it meet its mandated objectives.
Rather than cut the cash rate once and tighten again later as the market has factored in, we think the RBA would rather keep the cash rate unchanged at the current accommodative level for a longer period before gradually winding back the amount of policy accommodation from 2020 onwards.
Such a strategy preserves scarce monetary policy ammunition for a real shock and allows time for house prices to find their level after a tightening in lending standards designed to reduce financial stability risks. Furthermore, waiting also allows time for any election-related fiscal easing to become visible and time for offshore policy makers to support their economies.
The Fed has already signalled that it has moved from tightening to patience mode and signalled greater balance sheet flexibility. The recent rebound in risk appetite and lower government bond yields should see some unwinding of the tightening in financial conditions evident late last year and help extend the duration of the current global expansion. Chinese policy makers have announced and are likely to announce further measures to support their economy while minimising financial stability risks.
While we see near-term risk as tilted to the downside, three and 10 year government bonds yielding 1.73% and 2.20% (at the time of writing) look expensive in our view and are fully discounting significant downside risks and a very low terminal cash rate.
Views as at 31 January 2019.
Ongoing uncertainty about the pace and durability of the global expansion, coupled with the destabilising influence of Brexit negotiations and the limited shut down of the US government, led to a significant retrenchment in risk appetite. Against this backdrop, offshore equity markets fell sharply and there was further widening in credit spreads. Australian government bond yields fell sharply, benefitting from a watering down of tightening expectations at the shorter end of the yield curve and flight-to-quality flows at the longer end. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.5% over December.
The economy expanded by a less than expected 0.3% over the September quarter and led to some pushing back of tightening expectations early in the month. These briefly unwound, only to resume again as a strong rally in US yields, driven by a more dovish view of the US Federal Reserve (Fed) and flight-to-quality flows from the sell-off in equity and credit markets, dragged global and domestic yields lower.
US two and 10 year government bond yields both fell by 30 basis points (bps) to end the month at 2.49% and 2.68%. Australian government bond yields moved in sympathy, though there was more curve flattening evident in our market. The three year government bond yield ended the month 16 basis points (bps) lower at 1.85%, while the ten year government bond ended 27bps lower at 2.32% (levels not seen since late 2016).
In other domestic data readings, both the CBA Composite PMI and business conditions in the NAB Survey pointed to solid activity levels in November. Retail sales lifted by an expected 0.3% in October, while consumer sentiment held onto November’s strong lift despite further falls in house prices and volatility in financial markets.
Labour market conditions remained solid. The total number of jobs rose by 37,000 over November, though the ‘quality’ of job gains was down on previous months, with part time jobs up by 43,400 while the number of full time jobs fell by 6,400. That said, a lift in the participation rate to 65.7%, just shy of cyclical highs, was a positive development. With not all new entrants gaining work, there was a slight lift in the unemployment rate from 5.0% to 5.1%.
There was also some evidence that tightening labour market conditions were translating into higher wages. In September quarter Enterprise bargaining data, the average annualised wage increase per employee for deals struck in the quarter rose to 3.2%, well up from the 2.2% rate a year ago.
Despite partial demand indicators pointing to a stronger performance from the real economy over the December quarter, concerns that falling asset prices and weaker offshore growth could slow the economy going forward led markets to reassess their expectations for the likely path of the Reserve Bank of Australia (RBA) cash rate. Markets have moved from pricing in a 40% chance of a tightening by the end of 2019 a month ago, to pricing in around a 40% chance of a rate cut. There was a tightening in liquidity conditions in money markets which saw three and six month bank bill yields end the month 14bps and 9bps higher at 2.09% and 2.22%, respectively.
The negative sentiment experienced in equity markets also impacted credit markets, with the iTraxx Index widening 8bps to finish the month at 95bps. Primary markets were extremely quiet as this negative sentiment, coupled with the generally quieter end of calendar year, meant that most borrowers sat on the side lines either having pre-funded their borrowing obligations earlier in the year or being content to wait to see how market conditions develop early in 2019.
A gap has opened up between the markets and the RBA’s expectations for the path of the cash rate. While markets are now pricing in a 40% chance of an easing late 2019 to mid-2020, the RBA reiterated its view in the December Monetary Policy Meeting minutes that the next move in rates was most likely to be up rather than down and that there was no strong case for a near term move.
In assessing whether the recent rally is based on fundamentals rather than sentiment, or a mixture of both, it’s worth reviewing the RBA’s base case view and whether it is finding support in the data. Their expectations are for a period of above trend growth that incrementally absorbs remaining labour market slack and leads to a gradual lift in wages that will be reflected in a lift in underlying inflation to around 2.25% by the end of 2019. Such a view did get some support in the September quarter Enterprise bargaining data and the NAB Survey is consistent with near term monthly jobs gains of around 20,000 and enough to keep the unemployment rate trending lower. Furthermore, improvement in the fiscal position is reflective of stronger labour market conditions and a rebound in the nominal income side of the economy.
We still hold on to our view that the RBA will be in a position to gradually remove policy accommodation and have responded to recent developments by pushing back the timing of the first tightening into the first half of 2020. Thereafter we look for a gradual and drawn-out removal of policy accommodation that eventually returns the cash rate to 2.50% by 2022. We see this rate as being close to the economy’s neutral rate given the added grip that monetary policy has at time of high household debt levels.
Markets beginning to factor in monetary easing seem premature given the prospect of fiscal easing in an election year, a large pipeline of public infrastructure spending and support from a lower exchange rate. Macro-prudential measures were again eased, with the Australian Prudential Regulation Authority (APRA) lifting restrictions on interest only lending. This comes on top of their April move to remove the “speed limit” on investor lending and in aggregate should remove a source of downside pressure on housing prices.
At the time of writing, three and 10 year government bonds were yielding 1.8% and 2.29%, respectively. Both appear expensive, heavily discounting the downside risks to the growth and inflation outlook rather than the most likely path given current policy settings.
Views as at 31 December 2018.
Australian government bond yields traded in a relatively tight range, with an earlier rise in yields largely unwinding as risk appetite weakened on uncertainty about the durability and pace of the current global expansion. As sentiment weakened, earlier gains in Australian equities were reversed and there was some widening in credit spreads. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.24% over November.
At the shorter end of the yield curve, the yield on a three year Australian government bond rose to a high of 2.11%, before ending the month 2 basis points (bps) higher at 2.01%. Australian 10 year government bond yields moved in sympathy with US yields; the US 10 year government bond yield peaked at 3.23% following strong US labour market data and the domestic yield peaked at 2.76%.
US yields then began to rally as risk appetite soured and markets wound back US tightening expectations following comments from the Chairman of the US Federal Reserve that US interest rates were “just below” the broad range of estimates for the neutral rate. US two and 10 year government bond yields ended the month 8bps and 15bps lower at 2.79% and 2.99%. Australia’s longer end underperformed the US, with the domestic 10 year government bond ending the month 4bps lower at 2.59% and the spread between the two inverting by a further 11bps to end at -40bps.
Domestic data readings suggest that while the economy has momentum going into the end of the year, the pace of growth is moderating from the elevated levels experienced over the first half of the year. According to the NAB Survey, business conditions eased back in October, though still remain at above longer run levels. While business confidence continued to fall, there was a strong rebound in consumer confidence in November, despite recent falls in house prices and share markets.
Perhaps improving consumer sentiment reflected ongoing improvement in the labour market. The number of jobs in October rose by a stronger than expected 32,800, with the “quality” of those gains very high as the number of full time jobs rose by 42,300. Despite a lift in the participation rate, the unemployment rate held at 5% for the second month in a row. There was also some improvement in wages, with the wage price index gaining 0.6% over the September quarter and 2.3% over a year ago.
Private capital expenditure data for the September quarter was on the weaker side of expectations, falling 0.5% over the quarter. However, the previous quarter’s fall of 2.5% was revised to a fall of 0.9% and company expectations for 2018/2019 was for capex of $114.1bn, an upgrade of $11.6bn. On the consumption side, retail sales rose a modest 0.2% over September and a subdued 0.2% over the quarter in volumes terms. In the upcoming release of the national accounts, partial indicators point to a moderation in GDP growth to around 0.6% over the September quarter.
Despite periodic bouts of volatility and risk aversion, market tightening expectations were little changed. Markets still see little to no chance of a cash rate move out to mid-2019 and around a 40% chance of a tightening by the end of 2019. In money markets, three and six month bank bill yields ended the month 4bps and 6bps higher at 1.95% and 2.13%, respectively.
Credit markets didn’t escape periods of negative sentiment and were weaker, with the iTraxx Index widening to end the month at 87bps. Primary market activity was active and provided evidence of this weakness. Early in the month, Westpac managed to issue five year bonds at a credit spread of 95bps. Less than 3 weeks later, ANZ also issued five year bonds, however the credit spread was significantly wider at 103bps. Both deals were extremely well-supported by investors, with the Westpac deal being the largest corporate bond offering (they also issued a 3 year bond at the same time) since the Global Financial Crisis.
The November Statement on Monetary Policy forecasts from the Reserve Bank of Australia (RBA) have the economy growing at above trend rates over the next two years and the unemployment rate falling to 4.75% over the second half of 2020. Given uncertainty about the transmission of labour market tightening into wages and inflation, the RBA has ruled out any near-term tightening, noting that a period of stability would help create the conditions which would eventually allow them to begin removing policy accommodation.
In our view, further labour market improvement, along with the lagged effects of a lower currency, less fiscal drag and a large public sector infrastructure pipeline should see the RBA in a position to begin removing policy accommodation from late 2019 onwards. However, the large stock of household debt held will increase the potency of any cash rate increases and is the reason why we anticipate a more modest and drawn-out tightening cycle by historical standards.
We see the balance of risks tilted to the downside, reflecting uncertainty about the path of policy settings in Australia and offshore and the direction of house prices. These factors could result in the deferral of consumption and investment, and while unlikely to be powerful enough to get the RBA easing, they could significantly push back the timing of the first monetary tightening.
At the time of writing, the yield on a three year Australian government bond was around 2.0% and towards the expensive end of our fair value ranges. Further out along the curve, we see a 10 year Australian government bond yield of 2.59% as being modestly expensive, with upside pressure coming from the winding down of quantitative easing programs and cyclical inflation risks domestically and offshore as labour markets continue to tighten and spare capacity is reduced.
Views as at 30 November 2018.
Australian government bond yields rallied in the latter half of the month as a correction in US equity markets and concerns about the direction of Italian fiscal policy spilled over into a broader sell-off. During this risk-off period, Australian equities fell sharply, while domestic credit markets fared better with spreads little changed. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.48% over October, with price appreciation from lower yields adding to the income return.
At the shorter end of the yield curve, the yield on a three year Australian government bond rose to a high of 2.06%, before ending the month 6 basis points (bps) lower at 1.99% as markets pushed back the timing of monetary tightening. Australian 10 year government bond yields moved in sympathy with US yields; the US 10 year government bond yield peaked at 3.23% towards the middle of the month and the domestic yield peaked at 2.77%. As risk appetite soured, Australia’s longer end outperformed the US, ending the month 4bps lower at 2.63%, while US 10 year government bond yields ended 8bps higher at 3.14%.
Activity-based indicators point to ongoing economic momentum, with the CBA Manufacturing PMI improving in September and building on those gains according to preliminary October data. The CBA Services PMI remains in expansion territory, but showed signs of moderating. Business conditions remained elevated in September according to the NAB Business Survey and there was a modest bounce in confidence. Consumer confidence lifted to longer run levels in October after earlier falls on higher fuel costs and out-of-cycle lifts in some mortgage rates.
Labour market data for September provided a surprise, with the unemployment rate printing at 5% rather than the 5.3% rate the market expected. The “improvement” reflected a fall in the participation rate from 65.7% to 65.4% and a 5,600 lift in total employment. While the lift in employment was modest, the quality of gains was strong, with full time jobs gaining 20,300, while part time jobs fell by 14,700. The overall composition of the result meant that the lower than expected unemployment rate had minimal impact on market pricing.
The other key release for markets was the September quarter Consumer Price Index (CPI). Expectations for a lower result, driven by a government policy-led drop in child care costs, were realised with the headline rate lifting by 0.4% over the quarter and 1.9% over a year ago. Core inflation was also subdued, with the average of the Reserve Bank of Australia’s (RBA) statistical measures up 0.3% over the quarter and 1.7% over the last year. With the RBA having signalled that it would look through this result, the release had little market impact.
Despite the volatility in equity markets and mixed domestic data, there was only a modest watering down of tightening expectations. Markets still see little to no chance for a cash rate move out to mid-2019 and have cut the chance of a tightening by the end of 2019 from around 60% to 40%. In money markets, three and six month bank bill yields ended the month 3bps and 7bps lower at 1.91% and 2.07% respectively.
Against the backdrop of equity market volatility there was some widening in the iTraxx Index, which ended the month at 81.5bps. In contrast, spreads on investment grade securities were broadly stable. During periods of volatility, primary market activity tends to be minimal, but earlier in the month the domestic credit markets did see inaugural deals for both Port of Melbourne and Heathrow Airport, which provided investors further opportunity to add infrastructure companies to portfolios.
The RBA are likely to look through both the lower inflation outcome and fall in the unemployment rate to their December 2020 forecast level made in the August Monetary Policy Statement. On the inflation outcome, childcare detracted 0.2 percentage points off the quarterly outcome and was a result of government policy.
Furthermore, it appears as though a weaker exchange rate and the first and second round effects of higher oil prices are beginning to work their way through, with tradables inflation up 0.8% over the September quarter and 1.4% over a year ago. In contrast, the yearly tradables inflation rate in the 2017 September quarter was -0.9%.
With the economy poised to grow at above trend rates over 2018 and 2019, the RBA will have some confidence in its central case forecasts that the inflation rate will settle at 2% in 2019 and 2.25% in 2020.
While the fall in the unemployment rate to 5% may overstate the rate of improvement in the labour market, moves in the unemployment rate tend to be directional over time and forward labour market indicators point to further jobs growth. What remains uncertain and the reason why the RBA is in a patient mind-set is the transmission of labour market tightening into higher wages.
In our view, ongoing labour market improvement, along with the lagged effects of a lower currency, less fiscal drag and a large public sector infrastructure pipeline, should see the RBA in a position to begin removing policy accommodation in late 2019. However, the large stock of debt held by the household sector increases the potency of monetary policy and is the reason why we are looking for a modest and drawn out tightening cycle.
We see the neutral cash rate well below the RBA’s 3.5% estimate and as anchoring the domestic yield curve. At the time of writing, the yield on a three year government bond was around 2.0% and towards the expensive end of our fair value ranges. Further out along the curve, we see a 10 year Australian government bond yield of 2.63% (at the time of writing) as being modestly expensive, with upside pressure coming from cyclical inflation risks as labour markets tighten and output gaps close.
Views as at 31 October 2018.
Australian government bond yields rose as better domestic economic readings led markets to bring forward tightening expectations. Offshore factors played a role as well, with signs of strengthening wages growth, higher oil prices and higher US tariffs leading to a lift in offshore and domestic longer-dated yields. Weakness in the domestic equity market didn’t spill over into credit markets where spreads were largely unchanged. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 0.42% over September, with capital losses from higher yields more than offsetting the income return.
At the shorter end of the yield curve, the yield on a three year Australian government bond rose to as high as 2.14% before ending the month 7 basis points (bps) higher at 2.05%. At the longer end of the curve, the yield on a 10 year Australian government bond lifted to 2.75% before a late rally saw them finish 15bps higher at 2.67%. In the US, the Federal Reserve (Fed) tightened as expected and signalled further gradual tightening despite removing the reference to monetary policy being accommodative. US 2 and 10 year government bond yields ended the month 19bps and 20bps higher at 2.82% and 3.06% respectively.
On the data front, the latest set of national accounts showed that the Australian economy rose by a stronger than expected 0.9% over the June quarter and a well-above trend rate of 3.4% over the year. Consumption, dwelling investment, public sector demand and net exports helped drive the outcome, with business investment and stocks a minor drag on growth over the quarter.
Labour market data was also stronger than expected. Total employment surged ahead by 44,000 over August against market expectations for an 18,000 gain. The ‘quality’ of recent job gains has been strong, with fulltime jobs accounting for almost all of the 100,000 lift in the number of jobs over the last three months. The unemployment rate remained unchanged at 5.3% and in signs that above-trend growth is absorbing labour market slack, the underemployment rate fell to 8.1% as workers who wanted more hours were able to get them. The last time we saw this level was back in mid-2014.
Activity indicators suggest that momentum is carrying over into the September quarter, but that business and consumer sentiment dipped on the Coalition government leadership spill, out-of-cycle lifts in mortgage rates by some of the major banks and higher fuel prices. Business conditions in the NAB survey lifted to elevated levels again in August despite a fall in the confidence index from 7 to 4.
House prices continue to moderate, with the ABS house price index falling 0.7% over the June quarter. Home lending rose 0.4% in July, with investment lending down 1.3%, while owner-occupied lending rose by 1.3%. Credit rose 0.5% over August, with business lending up an encouraging 0.8%, while owner-occupied lifted 0.5% and investor lending by 0.1%.
Markets responded to the flow of economic data and offshore developments by bringing tightening expectations forward. Markets still see little to no chance for a cash rate move out to mid-2019. However, 30-day interbank cash rate futures contracts have moved from pricing in a 30% to 60% chance of a tightening by end 2019. Despite concerns of a bank funding squeeze going into quarter’s end, three month bank bill yields ended the month 1bps lower at 1.94%, while the 6 month bank bill ended the month unchanged at 2.14%.
Credit markets ended the month unchanged, with the iTraxx Index finishing at 74bps. Following the large amount of new deals launched in the prior month, September was far less active. Asset managers had put a lot of money to work in the previous month and not only were there fewer new deals in September, but the ones that did launch were generally not as over-subscribed as the previous month. One highlight was telecommunications company AT&T which completed its first deal in the domestic bond market, a triple-tranche deal raising $1.25bn in total.
With the Australian economy still having a degree of slack, the spread between the Australian and US cash rate (currently around -63bps) is set to invert even further as the Fed has signalled that it will lift the US cash rate by another 100bps by the end of 2019. To the extent that this would put downward pressure on the Australian dollar and provide a boost to growth and inflation, it would most likely be seen as a positive development by the Reserve Bank of Australia (RBA).
In recent comments, the RBA Governor, Philip Lowe, reiterated their expectation that a period of above-trend growth would absorb further slack and lead to a gradual lift in wages and inflation. The Governor still expects that the next move in the cash rate will be up, rather than down and occur against the backdrop of stronger growth in household incomes.
This view received some support in recent data releases, with labour force underutilisation rates falling against the backdrop of above-trend economic growth over recent quarters and signs across a range of wages measures that the period of wages disinflation had past. Further gains are needed before the RBA will be in a position to begin lifting rates.
We are still looking the RBA to commence a modest and drawn-out tightening cycle commencing late 2019. The case for an easing based on some combination of credit crunch fears, out-of-cycle lifts in mortgage rates and refinancing from interest-only to principal and interest appears unlikely following commentary from various RBA officials. These factors are more likely to delay the commencement of any tightening cycle.
While further exchange rate weakness from current levels would work in the opposite direction, so too would recent developments in fiscal policy. Stronger than expected revenue growth and delays in payments to the National Disability Insurance Scheme and States and Territories meant that the final outcome for the FY18 budget deficit at $10.1bn was $8.1bn better than expected. With Federal and State elections looming in Victoria and NSW, there is scope for personal tax cuts at a Federal level and expanded infrastructure spending at a State level.
We continue to see the shorter end of the curve as being well-anchored and the lift in the three year government bond yield to 2.05% as taking valuations closer to our fair value estimates. Further out along the curve, we see the recent rise in the 10 year Australian government bond yield from 2.52% to 2.67% at the time of writing as restoring some value. Nevertheless, we still see some upside pressure on longer-dated yields from a modest cyclical lift in global inflation and increases in sovereign debt supply as fiscal policy is eased at a time when central banks are moving from quantitative easing, to quantitative tightening.
Views as at 30 September 2018.
Australian government bond yields rallied as markets watered down their tightening expectations and the longer end of the curve benefitted from flight-to-quality flows during periods of trade tensions and financial volatility in some emerging market economies. The domestic equity market had a strong month while credit spreads were relatively stable. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned 0.81% over August, with capital gains from lower yields boosting the income return.
At the shorter end of the yield curve, the yield on a 3 year Australian government bond peaked early in the month at 2.12%, before ending the month 10 basis points (bps) lower at 1.98%. At the longer end of the curve, the yield on a 10 year Australian government bond lifted to as high as 2.73% early in the month, before financial instability in Turkey and an escalation in trade tension between the US and China saw them end the month 13bps lower at 2.52%. Domestic political events, which saw a change of leadership in the ruling Coalition government, had little discernible effect on yields, though the exchange rate ended the month 2.1% lower in trade weighted terms.
On the data front, June retail sales were stronger than expected, rising 0.4% over the month. Real retail sales for the quarter surged ahead by 1.2% and indicate that consumption is likely to make a solid contribution to GDP growth in the upcoming June quarter national accounts. Building approvals fell 5.2% in July from an upwardly revised 6.8% gain over June. Construction work done data for the June quarter suggests that dwelling investment will add to GDP growth, while the 2.5% fall in June quarter private capital expenditure suggests that business investment will detract from GDP growth. Overall, available partial indicators point to GDP growth of around 0.7% over the June quarter.
In the labour market, total employment fell by 3,900 in July after 58,200 jobs were added in June. The split between full and part time jobs was more flattering, with full time jobs lifting by 19,300, while part time jobs fell by 23,200. Hours worked rose by 0.2% and the unemployment rate fell from 5.4% to 5.3%, ahead of Reserve Bank of Australia (RBA) forecasts for a 5.5% rate by year end. Forward labour market indicators point to further jobs growth, with the ANZ Job Ads and DEWR Skilled Vacancies gaining over July. The NAB employment index rose from 5 to 10 in July, a level consistent with monthly jobs gains of around 23,000 per month over the next six months.
The RBA’s view that a tightening labour market will gradually lead to higher rates of wages growth got some tentative support in the June quarter wage price index. Private sector wages growth rose by 0.6% over the quarter (previously 0.5%) for a lift in the yearly rate from 1.9% to 2%. Public sector wages growth also gained by 0.6% for a yearly rate of 2.4%.
Markets responded to the flow of economic data and political developments by pushing back and watering down tightening expectations. Expectations for no change in the cash rate in 2018 remained unchanged and markets saw no chance of any monetary easing. For 2019, markets moved from pricing in a 25% chance of a move in May, to no chance and from a 75% chance of a tightening in December, to around 30%. Market pricing for a lift in the cash rate to 1.75% was pushed back from mid-2020 to late 2020. Three and 6 month bank bill yields both ended the month 1bps lower at 1.95% and 2.14%.
Credit markets ended the month unchanged, with the iTraxx Index finishing at 74bps. Against the backdrop of a generally positive company reporting season primary markets were very active, with many deals finding strong market support. By way of example, the CBA’s dual tranche $3.5bn bond deal received over $5bn of demand, while Suncorp’s $600m subordinated debt deal had over $2bn of demand. This indicates that domestic investors continue to have a large appetite for Australian corporate bonds with attractive yields.
While the RBA made some tweaks to its economic projections in the August Monetary Policy Statement, its underlying narrative of patiently waiting for wages and inflation to lift as above trend growth gradually absorbs excess capacity remains unchanged.
On the growth front, they left their forecasts for 2018 GDP growth of 3.25% unchanged from their May projections. The RBA continue to forecast a similar rate over 2019 and then have growth moderating to 3% over 2020 as the boost from expanding LNG export capacity fades. As these growth rates are above the economy’s trend rate, they see spare capacity being absorbed, allowing the unemployment rate to gradually fall from 5.5% at the end of 2018 to 5.0% by the end of the 2020.
There were more meaningful changes to their nearer term inflation forecasts. Headline inflation forecasts for 2018 were revised down from 2.25% in May to 1.75% and underlying inflation forecasts were revised down from 2% to 1.75%. From mid-2019 onwards they still have headline inflation running at a 2.25% rate out to the end of 2020. Underlying inflation is expected to lift more slowly, from a 2% rate at the end of 2019 to 2.25% from mid-2020 onwards.
The reason for the change is the large but uncertain impact of lower child care costs in the upcoming September quarter CPI. Energy and some education costs are also expected to be lower and the RBA’s view is that a lower quarterly result, most likely around 0.3%, would be a one-off which they would look through.
We broadly agree with the RBA’s underlying economic narrative and communications, noting that an eventual lift in the cash rate from record lows will come at a time when income growth has picked up. We still see the upcoming tightening cycle, returning monetary conditions from accommodative to neutral, as modest in size and drawn-out compared to earlier cycles.
Following revisions to the inflation outlook and major banks beginning to pass on higher funding costs, we have pushed back the timing of the first tightening to November 2019. We look for another tightening in February 2020 and then for the RBA to pause and tighten by another 50bps in 2021. We see the neutral cash rate as being well below the RBA’s 3.5% estimate given high stocks of household debt, anchoring the shorter end of the yield curve. At the time of writing, the yield on a three year government bond was around 1.95% and towards the expensive end of our fair value ranges.
Further out along the curve, we see a 10 year Australian government bond yield of 2.50% at the time of writing as being modestly expensive. While differences in Australia’s fiscal and monetary policy positions suggest our longer end can outperform the US, it is still vulnerable to lifts in US or offshore yields. These could eventuate from any easing in global trade tensions, upward revision to growth and inflation expectations, and increases in debt supply as fiscal policy is eased at a time when central banks are moving away from expanding their balance sheets.
Views as at 31 August 2018.
Australian government bond yields continued to trade in relatively tight ranges and ended the month slightly higher in yield. Risk appetite rebounded as trade tensions between Europe and the US eased and Chinese authorities announced steps to support their economy. Domestic and offshore equity markets performed well and there was some tightening in credit spreads. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned 0.16% over July, with modest capital erosion from slightly higher yields offsetting some of the income return.
At the shorter end of the yield curve, the yield on a 3 year Australian government bond peaked at 2.14% before ending the month 2 basis points (bps) higher at 2.08%. At the longer end of the curve, the yield on a 10 year Australian government bond lifted to as high as 2.72% towards the end of the month as markets began to discount a shift in the Bank of Japan’s (BOJ) ultra-accommodative policy stance. Despite a modest rally at the end of the month as markets were disappointed by the subtle policy changes the BOJ made, the yield on an Australian 10 year government bond ended the month 2bps higher at 2.65%.
The tone of domestic activity and labour market data was a little more on the upbeat side this month, but recent strength has yet to translate into a lift in consumer price or wages pressures. Of the activity indicators, the June CBA and AIG PMIs remained in expansion territory, with manufacturing sector readings particularly strong. Business conditions remained at elevated levels in the July NAB Survey, while business confidence continued to ease back from well above long run levels at the start of the year, to around longer run levels in July.
In contrast, consumer sentiment jumped sharply in July, with strength evident in the forward-looking components like the time to buy a major household item and one year ahead family finances. The prospect of personal tax cuts and the recent lift in the minimum wages appear to have played a role. Improving sentiment seems to be showing up in spending, with retail sales up a stronger than expected 0.4% in June.
Labour market outcomes for June were much stronger than expected, with total employment lifting by 50,900, against market expectations for a 12,000 gain. The composition of the gain was also strong, with full time jobs rising by 41,200 and part time by 9,700. The unemployment rate remained unchanged at 5.4%, while the participation rate lifted from 65.5% to 65.7%. Forward labour market indicators were more mixed in June and point to a moderation in the rate of job gains over the second half of the year.
The consumer price index for the June quarter came in broadly in line with market expectations and largely in line with what the Reserve Bank of Australia (RBA) was looking for in its May Monetary Policy Statement forecasts. Headline inflation rose by 0.4%, slightly less than market expectations for a rise of 0.5%, giving a yearly rate of 2.1%. The average of the RBA’s statistical measures rose by 0.5% for a yearly rate of 2.0%. Both headline and core inflation yearly rates are settling around the bottom end of the RBA’s 2% to 3% target band.
Even though there were a number of stronger economic readings, there was little shift in the market’s cash rate expectations. Markets still see no chance of a lift in the cash rate in 2018. For 2019, markets continue to assign around a 25% chance for a move in May and 50% chance for an August move. By December 2019, markets have yet to fully price in a tightening, with that month’s 30-day interbank cash rate futures contract ending the month at 1.695%. Three and 6 month bank bill yields ended 15bps and 7bps lower at 1.96% and 2.15%, as funding conditions eased after the quarter and financial year end.
Credit markets were stronger as risk appetite recovered. The iTraxx Index tightened by 7bps to end the month at 74bps. Primary markets were extremely quiet with three of the four major banks all printing deals offshore. The domestic highlight was the 20 year deal from Zurich Insurance Company, which marked one of the longest corporate bond deals in the domestic market’s history. The domestic reporting season occurs in August where market participants will get up-to-date insight on company performance, as well as gain greater insight into borrowing programmes for the remainder of 2018 and beyond.
Market outlookWe still see the shorter end of the Australian yield curve as remaining well-anchored and the RBA as unlikely to begin a modest and drawn out tightening cycle until later in 2019. While labour force data was better than expected and supportive of the RBA’s base case view that a period of above trend growth would gradually reduce labour market slack and lead to a lift in wages, further gains will be needed to shift the RBA out of its patient ‘policy on hold’ mind-set.
The latest CPI data hasn’t provided the RBA with a reason to change its reaction function either. While the headline rate came in under market expectations, the miss mainly reflected falls in fresh fruit and vegetable prices and these are likely to reverse over the quarters ahead as drought conditions intensify. Core measures continue to run around a 2% yearly rate and the RBA doesn’t see this rate lifting until the second half of 2020.
The barrier to any easing remains high and any move down would have to pass the RBA’s public interest test. On the trade “war” front, there appears to have been some easing in tensions between the US and Europe and steps by Chinese authorities to support growth helps shore up the global growth outlook. On the credit front, the rate of credit growth is moderating, with most of the slowdown reflecting a policy-driven flattening in investor housing lending. Credit for owner-occupier housing rose by a solid 7.8% over the 12 months to June, while business credit rose by 3.4% and suggests that credit demand is still holding up despite a minor lift in some lending rates.
We agree with the RBA’s view in the minutes from the July board meeting that a strengthening economy and further labour market progress means that the next move in the cash rate would more likely be an increase than a decrease. The lift in the three year government bond yield from early July’s low of 2.02% to 2.11% at the time of writing has taken them from being modestly expensive to fairly valued.
Further out along the curve, we see a 10 year Australian government bond yield of 2.70% at the time of writing as being modestly expensive. While differences in Australia’s fiscal and monetary policy positions suggest our longer end can outperform the US, it is still vulnerable to lifts in US or offshore yields. This could eventuate from any easing in trade tensions, upward revision to growth and inflation expectations, and increases in debt supply as fiscal policy is eased at a time when central banks are moving away from expanding their balance sheets.
Views as at 31 July 2018.