Australian economic view

01/12/2018

Frank Uhlenbruch, Investment Strategist in the Australian Fixed Interest team, provides his Australian economic analysis and market outlook.

December 2018

Market review

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.

Market outlook

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.

November 2018

Market review

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.

Market outlook

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.

October 2018

Market review

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.

Market outlook

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.

September 2018

Market review

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.

Market outlook

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.

August 2018

Market review

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 outlook

We 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.

July 2018

Market review

After an initial lift on stronger US and domestic data, a further bout of trade tensions saw yields end the month modestly lower. Risk appetite waned as these tensions escalated and resulted in some widening in credit spreads and volatility in equity markets. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, had a solid month, gaining 0.48% as falling yields resulted in capital gains that boosted the income return. Over the past 12 months, the sector has returned 3.09%.

At the shorter end of the yield curve, the yield on a 3 year Australian government bond peaked at 2.22% before ending the month 4 basis points (bps) lower at 2.06%. At the longer end of the curve, the yield on a 10 year Australian government bond lifted to as high as 2.84%, before rallying steadily to end the month 4bps lower at 2.63%.

On the monetary policy front, the US Federal Reserve (Fed) lifted the Fed funds rate by 25bps to a new range of 1.75% to 2%. With fiscal policy providing significant support to demand and the Fed expecting ongoing labour market gains and higher inflation, they signalled a further two policy moves this year and another 3 in 2019. If the Fed follows through on these moves, the stance of US monetary policy would shift from accommodative to slightly tight.

In Europe, the European Central Bank (ECB) signalled that it would wind up its asset purchase programme by the end of the year, but also that there would be no lift in the policy rate until the September quarter of 2019 at the earliest. US 10 year government bond yields ended the month unchanged at 2.86% while the European equivalent ended 4bps lower at 0.30%.

The Australian economy started the year on a strong note, with real gross domestic product (GDP) lifting by 1% over the March quarter, for an above trend rate of 3.1% over a year ago. All components of demand made modest positive contributions to the quarter’s growth rate. The strongest contribution came from net exports, as coal exports rebounded and new LNG capacity came on.

Partial demand indicators suggest that momentum has carried over into the June quarter. Of the activity indicators, the May CBA and AIG PMIs remain in expansion territory, with services sector readings particularly strong. Business conditions and employment intentions fell in the May NAB Survey, but remain at elevated levels. Of the consumption indicators, retail sales were a little stronger than expected, lifting 0.4% over April. There was also a small bounce in June consumer sentiment following the announcement of personal income tax cuts in the May Budget.

While forward labour market indicators point to ongoing labour demand, the composition of May’s labour force report was on the lacklustre side. While total employment lifted by 12,000, the number of full time jobs fell by 20,600, with a 32,600 lift in part time jobs driving the month’s overall gain. A small fall in the participation rate meant that the unemployment rate fell from 5.6% to 5.4%.

Steps to curb investor lending continue to work their way through the economy. Overall credit growth for May was 0.2%, with owner occupied lending up 0.6%, while investor housing lending was flat. A pull-back in business lending after earlier strength was a key factor behind the sluggish result. The ABS house price index fell 0.7% in the March quarter, with higher frequency indicators pointing to further falls in the June quarter.

Against this backdrop, markets continued to water-down their tightening expectations for 2019. The chances for a May 2019 rate rise have dropped from around 50% to 25%. Similarly, the chances for an August 2019 rise slipped from 75% to 50%. By November 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 1.69%. Three and 6 month bank bill yields both ended 13bps higher at 2.11% and 2.22% as funding conditions tightened going into the end of quarter and financial year.

Credit markets were softer over the month, with the iTraxx Index widening 10bps, to end the month at 81bps. Most of this weakness occurred towards the end of the month following an escalation in trade tensions. Primary markets were generally quiet as issuers monitored market conditions. One deal of note was from Westpac, which saw $725 million of new tier 2 subordinated notes issued at 180bps above the BBSW rate, offering some value to domestic investors in a segment that has been in low supply.

Market outlook

The shorter end of the Australian yield curve remains well-anchored. In recent comments at the Forum on Central Banking, Governor of the Reserve Bank of Australia (RBA), Philip Lowe, reiterated the ‘public interest test’ and its relevance in setting policy along with the price stability and full employment objectives. He noted that central banks across the globe were being challenged by an economic system that was less inflation-prone than in the past. In Australia’s case, he argued that the RBA could patiently accept a period of lower inflation, provided jobs were there and that growth was heading in the right direction to absorb any slack. This remains their base case forecast.

The RBA continue to look for above-trend economic growth over the next couple of years that absorbs some labour market slack and ultimately leads to a lift in the rate of wages growth. In his Forum comments, Governor Lowe indicated that recent RBA commentary “talking up” the wages outlook was a new and deliberate policy step to help push up inflation expectations. There appear to be early signs of building wage pressures, with business reporting that labour is becoming increasingly harder to find and the RBA noting that firms had begun to revise up their wage expectations. Confirmation that these pressures have translated into a lift in the wage price index will be needed before the RBA can commence normalising policy settings.

However, the RBA’s job has been made more challenging by a recent tightening in bank funding conditions that has led to some modest out-of-cycle increases in lending rates from non-major banks, with major banks under pressure to follow. Concerns are that a tightening in lending standards and slowing in housing credit could lead to a more pronounced fall in housing prices, with stronger negative wealth effects on consumption. The RBA Governor argues that the ‘public interest test’ is not met by cutting the cash rate given the current growth and labour market configuration on financial stability grounds. We have responded to these tensions by pushing back the timing of our first tightening into the second half of 2019.

We still regard the stance of monetary policy as accommodative and note that the passing of personal tax cut legislation and a weakening in the exchange rate are supportive of the growth and inflation outlook. In conjunction with a strong public sector infrastructure pipeline and elevated business conditions, we still see room for the RBA to take the stance of monetary policy to more neutral settings over time, barring any negative global trade shocks. While we see some of the recent rally in three year government bond yields as justified by fundamentals, yields at close to 2%, at the time of writing, were moving towards the expensive end of our fair value band.

Further out along the curve, we see the recent rally in 10 year Australian government bond yields from 2.92% mid-May to around 2.62% at the time of writing, as taking them from being fairly valued to 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 geo-political or 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 30 June 2018.

June 2018

Market review

Australian government bond yields moved in sympathy with US yields, which initially rose as markets factored in further US Federal Reserve (Fed) tightening and the inflationary impact of higher oil prices. Perceptions of a shift towards a more dovish tone in Fed commentary and flight-to-quality flows triggered by a sharp jump in Italian political risk saw yields end the month lower. Credit spreads ended wider as risk appetite waned. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, had a strong month, gaining 0.69% as falling yields resulted in capital gains that boosted the income return.

At the shorter end of the yield curve, the yield on a 3 year Australian government bond peaked at 2.24% before ending the month 8 basis points (bps) lower at 2.10%. At the longer end of the curve, the yield on a 10 year Australian government bond lifted to as high as 2.92% before rallying steadily to end the month 10bps lower at 2.67%. Overall, moves were broadly in line with their US counterparts, with US 2 and 10 year treasuries closing 6bps and 9bps lower at 2.43% and 2.86% respectively.

Domestic data soundings continued to return the familiar readings of strength in activity-based measures and subdued price pressures. Despite recent financial market volatility and fall-out from the Financial Services Royal Commission, momentum in the manufacturing, construction and services sectors continued unabated, with the April CBA and AIG PMIs all remaining firmly in expansion territory. These trends were also reflected in the April NAB Business Survey, in which business conditions surged to the highest level in 10 years and employment intentions jumped sharply.

While business conditions remained strong, the pace of consumption growth was more subdued. Retail sales were flat over March after lifting by 0.5% over the previous month. For the upcoming March quarter national accounts, the 0.2% lift in real retail sales over the quarter suggests that consumption will not be a major contributor to GDP growth.

Building approvals fell 5% in April after gaining 3.5% over the previous month. Looking through recent volatility, private sector housing approvals have been improving over the past few months, while apartment approvals have been easing. Overall, dwelling investment is poised to modestly detract from GDP growth over the March quarter.

March quarter private capital expenditure data and a sharp improvement in the trade account suggest that both business investment and net exports will add to GDP growth. In aggregate, partial demand indicators suggest GDP growth will accelerate from the 0.4% rate in the December quarter.

There was some improvement in labour market conditions, with employment lifting by 22,600 over April. The composition of gains was on the stronger side, with full-time jobs lifting by 32,700 and hours worked up by 1.1%. With employment gains not enough to absorb the number of new entrants from a lift in the participation rate to 65.6%, the unemployment rate ticked up to 5.6% from 5.5%. Despite a recent surge in employment, wages growth remains modest and indicative of some ongoing labour market slack. The wage price index for the December quarter rose a less than expected 0.5%, leaving the yearly rate unchanged at 2.1%.

Against this backdrop, markets watered down their tightening expectations for 2019. While still assigning around a 50% chance of a tightening in May 2019, markets moved from fully pricing in a tightening in August 2019 to around an 80% chance. By October 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 1.72%. Three and 6 month bank bill yields both ended the month 6bps lower at 1.98% and 2.09%.

Credit markets were softer over the month, with the iTraxx Index widening 5bps, to end the month at 70bps. Most of this weakness occurred towards the end of the month as concerns about the Italian political outlook flared. Primary markets were particularly active in the first half of the month, with both NAB and ANZ pricing large-sized bond deals. A noteworthy primary development was the successful inaugural bond deal by Virgin Australia, which issued $150m of senior unsecured bonds with a sub-investment grade credit rating of B-.

Market outlook

We suspect that the recent rally in yields on heightened Italian political risk will ultimately prove overdone given the outlook for ongoing global growth supported by accommodative monetary and fiscal stances. In their latest Economic Outlook, the OECD looks for global growth to lift from 3.8% in 2018 to 3.9% in the following year. They note that around three quarters of OECD countries are undertaking fiscal easing.

On the domestic fiscal outlook, the latest Budget shows that the worst of the drag from fiscal policy may be behind us. Since 2013/2014, the Budget balance has improved by 3.1% of GDP and over that period the Reserve Bank of Australia (RBA) cut the cash rate 1%.

Looking ahead, the Australian Government projects the Budget balance will shift from an underlying deficit of 1% of GDP in 2017/2018 to a surplus of 0.1% of GDP in 2019/2020. Much of the improvement is driven by a recovery in tax revenues and with the Government committing itself to a 23.9% of GDP tax ceiling, it announced a three phased plan to reduce personal income tax out to 2024/2025. At the margin, fiscal policy has turned a little more accommodative and takes some of the pressure off monetary policy to provide an offset.

While public sector infrastructure spending announced in recent Federal and State government budgets will help support growth and employment, the lagged effects of around a 7% fall in Australia’s trade weighted index since July 2017 should also help.

The RBA freshened up their growth and inflation forecasts in their May Statement on Monetary Policy and there was little change to their narrative of a period of above trend growth (3.25% for both 2018 and 2019) that gradually erodes spare capacity and leads to a pick-up in wages and inflation. The Deputy Governor, Guy Debelle, noted in a recent speech that should their central case forecasts come to pass, higher interest rates were likely to be appropriate, but not in the near term.

Our base case view remains for the RBA to commence a modest tightening cycle in 2019, with an initial burst of 50bps of tightening. Our sense is that markets may have pushed back tightening expectations too far, though we are mindful of the potential drag to the consumption outlook from negative wealth effects from moderating house prices. Overall, we still see the shorter end of the curve well-anchored, with the large stock of household debt limiting how far the RBA has to lift the cash rate before monetary conditions return to neutral levels.

Further out along the curve, we see the recent rally in 10 year Australian government bond yields from 2.92% mid-May to around 2.68% at the time of writing, as taking them from being fairly valued to modestly expensive. While 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 due to any easing in political tensions, upward revision to growth and inflation expectations, increases in debt supply as fiscal policy is eased, or lift in term premia.

Views as at 31 May 2018.

May 2018

Market review

Australian government bond yields ended the month higher as an easing in trade tensions saw markets refocus on the outlook for growth and inflation and the rate at which policy accommodation would be removed. A recovery in risk appetite supported equity markets and a narrowing in credit spreads. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned -0.35% over April, with capital erosion from higher yields more than offsetting the income return.

At the shorter end of the yield curve, the yield on a 3 year Australian government bond peaked at 2.27% before ending the month 13 basis points (bps) higher at 2.18%. At the longer end of the curve, the yield on a 10 year government bond lifted to as high as 2.87% before a late month rally saw them finish 17bps higher at 2.77%. Australian government bonds outperformed their US counterparts, with US 2 and 10 year treasuries closing 22bps and 21bps higher at 2.49% and 2.95% respectively. The spread between Australian and US 10 year government bonds became more inverted, ending the month at -18bps and reflective of the different fiscal paths both countries are on.

Domestic data readings were mixed but consistent with a pick up in the rate of economic growth from the softer levels seen in the December quarter. Activity-based measures remain in expansion territory, with the CBA composite PMI lifting to 55.4 in March. While there was some pull-back in the NAB Business Survey from February’s record high levels, business conditions and employment intentions remained at elevated levels in March.

Although consumer sentiment has eased modestly since the beginning of the year, there was a strong 0.6% lift in retail sales over February, allaying fears that high levels of household debt, easing house prices and renewed equity market volatility were curtailing consumption. Building approvals fell 6.2% in February following a 17.2% gain over the previous month.

Despite forward labour market indicators pointing to ongoing labour demand, the 4,900 lift in total employment for March was well below market expectations for a 17,500 gain. There has been a distinct cooling in labour market conditions from the booming levels of 2017. Total employment has lifted by an average of 12,000 per month over the first three months of 2018, compared to monthly average gains of 34,600 over 2017. A small fall in the participation rate from high levels meant that the unemployment rate fell from 5.6% to 5.5% over March.

The consumer price index for the March quarter came in broadly in line with market expectations and slightly ahead of what the Reserve Bank of Australia (RBA) was looking for in its February 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 1.9%. 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 at the bottom end of the RBA’s 2% to 3% target band.

Against this backdrop, there was little movement in expectations for the timing of the first tightening. Markets continue to assign just over a 50% chance of a tightening in May 2019 and are fully pricing in the first tightening in August 2019 with that month’s 30-day interbank cash rate futures contract ending the month 1bps higher at 1.795%. Three and 6 month bank bill yields peaked at 2.08% and 2.19%, before a modest improvement in funding conditions saw them end the month 1bps and 2bps higher at 2.04% and 2.15%.

Credit markets experienced a positive month, with the iTraxx Index tightening 5bps to end the month at 65bps. This was aided by the performance of major bank bonds, which despite Royal Commission, related volatility in their equity prices and ongoing short term funding pressures, managed to tighten in credit spread. Primary markets were relatively quiet, with the Brisbane Airport issue of $350m of BBB rated 7 year bonds a highlight. Their first issue in the domestic bond market in four years was met with extremely strong demand from domestic investors that was over $1bn.

Market outlook

The latest forecasts from the IMF have global growth lifting from 3.8% in 2017, the fasted rate since 2011, to 3.9% for both 2018 and 2019. Following pro-cyclical US fiscal easing, the IMF lifted their US growth forecasts to 2.9% in 2018 and 2.7% for 2019. Global central banks are responding to the better outlook depending on how much slack they perceive their economies to have.

In the US, the US Federal Reserve (Fed) has begun removing policy accommodation and projected that the Fed funds rate will lift to long run levels by the end of 2019. In Europe, where growth has moderated from very high rates, European Central Bank (ECB) President, Mario Draghi, has signalled that monetary policy will remain accommodative for the time being. The ECB’s asset purchase programme will run until at least until September 2018 and Draghi reiterated that policy rates will remain at their present levels for an extended period.

We will get updated forecasts from the RBA in early May and from Treasury in the upcoming Federal Budget. The latest CPI outcome is likely to see the RBA lift their near term inflation forecasts, but keep their broader narrative of a period of above trend economic growth that gradually reduces spare capacity in the economy intact.

While minor and limited out of cycle lifts in some lending rates point to a marginal tightening in monetary conditions, the lagged effects of an 8.5% fall in Australia’s trade weighted index from July 2017 highs is working in the opposite direction. The prospect of further federal and state government infrastructure spending and mooted personal tax cuts in the upcoming Federal Budget should also act to support the growth outlook.

The latest minutes from the March RBA board meeting show that board members now hold the same view as the Governor in that the next move in rates will be up. Given the gradual rate at which the RBA expects a tightening in labour market conditions to flow through into wages and inflation, they see no near term case for a lift.

Our base case view remains for the RBA to commence a modest tightening cycle with an initial burst of 50bps of tightening in the first half of 2019. Thereafter, we look for a pause as the RBA assesses the economy’s response given current levels of high consumer debt. If the growth and inflation outlook evolve as expected, we see scope for another burst of 50bps of tightening in the second half of 2020 that would take the stance of policy to broadly neutral. Given such an outlook, we see the shorter end of curve as fairly well anchored, but note that expectations for the timing of the first tightening could be bought forward given the strong global growth outlook and prospective fiscal initiatives.

Further out along the curve, we see 10 year Australian government bond yields at around 2.76% as being modestly expensive. While 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 due to any easing in trade or geo-political tensions, upward revision to growth and inflation expectations, reduction in central bank balance sheets or lift in term premia.

Views as at 30 April 2018.

April 2018

Market review

Australian government bond yields fell over the month, with fears of an escalation in trade tensions between the US and China, driving a risk-off period that saw the longer end of the curve well-supported. During this period, equity markets weakened and there was some widening in credit spreads. Little evidence of pricing power in the economy and near-term bank funding pressures led the market to push back the timing of the first rate rise to mid-2019. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned 0.84% over March, with price appreciation from falling yields more than offsetting the negative impact of widening credit spreads.

In the US, the US Federal Reserve (Fed) lifted the Fed funds rate by 25 basis points (bps) and signalled that their upwardly revised growth and inflation forecasts meant that policy accommodation would continue to be removed at a gradual pace. US two year Treasury yields peaked at 2.34% following the policy move, before ending the month 2bps higher at 2.27%. In contrast, the three year Australian government bond yield ended the month 4bps lower at 2.05%. Australia’s longer end continued to outperform the US, with the yield on a 10 year Australian government bond ending the month 21bps lower at 2.60%. In contrast, the yield on a US 10 year Treasury closed the month 12bps lower at 2.74%.

According to the December quarter national accounts, the Australian economy grew by a modest 0.4% over the quarter and 2.4% over the year. Strength in consumption and public investment was partly offset by weakness in housing, business investment and net exports. The latter in particular was affected by weather events and a rapid turnaround in January’s trade balance from a deficit of $1.15bn in December to a surplus of $1.05bn, which suggests that the external sector will add to growth over the March quarter.

Activity-based measures point to underlying momentum, with the CBA manufacturing and services PMIs lifting in February and remaining in expansion territory. These trends were reflected in the NAB Business Survey, where business conditions rose to a new high in February. Despite a modest easing in business confidence, forward-looking components were particularly strong with forward orders, employment intentions, wages costs and capital expenditure plans all rising strongly.

There were also tentative signs of a broader lift in non-mining capital expenditure plans in the December quarter private capital expenditure survey. For the first time since 2012/13, total capital expenditure plans for the year ahead were raised, rather than dragged down by falls in mining investment. The first estimate for 2018/19 private capital expenditure was $84bn, compared to the first estimate for 2017/18 of $81.2bn, and suggests that business investment will add to growth over the year ahead.

Labour market conditions remain solid despite recent sampling volatility. Total employment rose by 17,500 over February, with a 64,900 lift in full time employment more than reversing a 53,200 fall over January. Part time employment fell 47,400 after gaining 65,600 in January. Underlying labour market strength continues to draw new entrants, with the participation rate lifting to 65.7% and resulted in a slight lift in the unemployment rate to 5.6%. While forward-looking labour market indicators still point to further moderate gains, a slight uptick in the underutilisation rate from 13.8% to 13.9% suggests that the labour market still has some slack in it.

A notable development over the month was a sharp rise in short-term money yields on the back of heightened demand for short-term funding by Australian banks ahead of their 31 March 2018 balance date. Similar trends have been evident in the US where the prospect of US corporations bringing foreign earnings back onshore and massive government of issuance of Treasury bills have resulted in a significant widening in the spreads between LIBOR and expected cash rates. This has made it more expensive for Australian banks to tap offshore funding lines, thus forcing them to access funding at higher rates in the domestic market. Reflecting these dynamics, three and six month bank bills ended the month 25bps and 17bps higher at 2.03% and 2.13% respectively.

Credit markets also suffered from the negative sentiment that gripped risk assets, with the iTraxx ending the month 2bps wider at 71bps. The weakness over the month was mainly evident in bank spreads, as funding pressures seen in the short end of the market (under one year) spread to longer tenors, with five year major bank spreads moving wider by over 10bps over the month. Primary markets were relatively quiet, however a noteworthy issue was by NAB which issued $1.5bn of covered bonds in the domestic market early in the month.

Market outlook

It is too early to tell whether the first salvo of tit-for-tat trade sanctions between the US and China could develop into a full blown trade war that derails the current global recovery. In his post-FOMC comments, Fed Chair, Jerome Powell, noted that trade developments to date had not caused FOMC members to reassess their outlook for a period of above trend growth that saw median 2020 inflation and Fed funds rate projections lift to 2.1% and 3.4% respectively. Early estimates point to only marginal downside risk to the 6.5% growth target Chinese authorities set for 2018.

Most likely, the Reserve Bank of Australia (RBA) will keep an eye on these developments as it will watch for signs that the recent lift in bank funding costs could lead to an out-of-cycle lift in lending rates. While funding pressures are expected to ease, the lack of pricing power in the economy suggests that the RBA is under no pressure to change the currently accommodative policy stance. While the RBA maybe prepared to keep policy on hold for longer, we still see limited scope for the RBA to ease from here given its concerns about the risks to economic and financial stability from a further build-up in high levels of consumer debt.

Like the RBA Governor, we expect that the next move in the cash rate will be up. We have pushed back the timing of our first rate rise into early 2019 to allow more time for labour market improvement to translate into a lift in wages. We still believe that the initial burst of tightening will be 50bps and that the RBA will then pause to assess the economy’s response given current levels of high consumer debt. If the growth and inflation outlook evolve as expected, we see scope for another burst of 50bps of tightening in the second half of 2020 that would take the stance of policy to broadly neutral. Given such an outlook, we see the shorter end of curve as fairly well anchored and fair value for three year Australian government bonds in the 2.1% to 2.2% range.

Further out along the curve we see 10 year Australian government bond yields at around 2.59% as being moderately expensive. While 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 due to any easing in trade tensions, upward revision to growth and inflation expectations, reduction in central bank balance sheets or lift in term premia.

Views as at 31 March 2018.

March 2018

Market review

US bond yields lifted sharply as markets absorbed the implications of a lift in wages growth and further fiscal stimulus at a time when the US economy is growing strongly. Fears that higher US rates could derail the current recovery initially led to a risk-off period that saw global equity markets fall and credit spreads widen, though there was some retracement towards the end of month. Mixed domestic data and a lack of policy urgency from the Reserve Bank of Australia (RBA) saw Australian yields lower at the shorter end of the yield curve, and little changed at the longer end. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned 0.29% over February, with most of the gains coming from the income return.

At the shorter end of the yield curve, the three year Australian government bond yield peaked early in the month at 2.18%, before finishing the month 6 basis points (bps) lower at 2.09%. Australia’s longer end outperformed the US, with the yield on a 10 year Australian government bond ending the month unchanged at 2.81%. In contrast, the yield on a US 10 year Treasury closed the month 16bps higher at 2.87%. The last time the spread between the two inverted was briefly in May 1998 and for a longer period in the early 1980s. Domestic data readings were mixed and continued the recent theme of strength in activity-based measures and subdued price pressures. Late 2017 momentum in the manufacturing, construction and services sectors looks to have carried over into January, with the CBA and AIG PMIs all firmly in expansion territory. These trends were reflected in the NAB Business Survey, where business conditions and capacity utilisation levels climbed back to historically high levels.

On the softer side were falls in building approvals (down 20%) and retail sales (down 0.5%) over December. These falls follow earlier strength and real retail sales rose by 0.9% over the December quarter, suggesting that consumption will rebound strongly in the upcoming national accounts. Construction work done data for the December quarter suggests that residential and engineering will act as a drag on GDP growth, while non-residential should add to growth.

Australia’s trade balance looks to have deteriorated over the quarter, with weather holding back exports and imports lifting. Net exports are expected to be a significant drag on economic growth over the December quarter.

The rate of improvement in the labour market slowed in January, with total employment lifting by 16,000. Sampling volatility looks to have reappeared, with full time employment falling 49,800 and part time lifting by 65,900. The unemployment rate remained steady at 5.5%, while the participation rate eased back from high levels. Forward labour market indicators point to further moderate gains, with the ANZ Job Ads and DEWR Skilled Vacancies recording solid gains in January.

Despite 403,300 jobs being added over the last 12 months, wages pressures remain subdued and indicative of some remaining slack in the labour market. The wage price index rose 0.6% over the December quarter and 2.1% over a year ago. Wages growth remains strongest in the public sector, with yearly growth of 2.4% compared to 1.9% in the private sector.

Against this backdrop, money market yields reversed an early rally, with three and six month bank bills ending the month 1bps and 3bps higher at 1.79% and 1.96% respectively. Dovish RBA commentary and the lack of pricing power in the economy led markets to push back the timing of the first lift in the cash rate towards mid-2019. The April 2019 30-day interbank cash rate futures contract ended the month at 1.76% and was the first contract to fully price in a 25bps lift in the cash rate.

The volatility that engulfed financial markets during the start of February impacted credit markets and in particular sub-investment grade sectors. However by the conclusion of the month, credit spreads had regained most of their initial weakness and closed the month broadly stable. The domestic reporting season was generally positive for credit investors, with limited shareholder-friendly behaviour and credit profiles remaining intact.

Market outlook

The February Monetary Policy Statement (MPS) and a swathe of commentary from the RBA Governor and senior officials left the broader economic narrative unchanged. Growth is still expected to lift from a 2.5% pace in 2017 to 3.25% over 2018 and 2019, before easing back to 3% in 2020. A period of above trend growth is expected to gradually use up existing spare capacity and eventually lead to a lift in wages and underlying inflation. Underlying inflation is only expected to reach 2% by mid-2019 and lift to 2.25% by mid-2020. While the RBA expect spare capacity to be absorbed by above trend growth, they only have the unemployment rate falling from 5.5% currently to 5.25% in mid-2020, against a natural rate of 5%. By their reckoning, there is still some slack at the end of the outlook period.

The Governor continued to make the point that given Australia has more slack than other economies, it can afford to wait for signs of lifting wages before moving on monetary policy. Given the need to balance the speed at which it can meet its inflation target and the risks to economic and financial stability from a further build up in high levels of consumer debt, the RBA seem disinclined to ease further. The Governor also ruled out the chance of a near term tightening in comments he made at the A50 Dinner earlier in the month. That said, the Governor again reiterated that if the outlook unfolded as expected, the next move in rates will be up.

We still see the window for an initial burst of 50bps of tightening (which unwinds the 50bps of ‘emergency easing’ in mid-2016), as opening up later this year or early 2019. Thereafter, we look for the RBA to pause and follow up with another burst of 50bps of tightening over 2020/2021, to return the monetary policy stance from accommodative to broadly neutral. We are sympathetic to the Assistant Governor’s recent observation that “from the perspective of monetary policy, high debt levels will influence the calibration of interest rate changes” and view the neutral cash rate as sitting around 2.7%, rather than the RBA’s estimated 3.5% level. Given such an outlook, we see the shorter end of curve as fairly well anchored and fair value for three year Australian government bonds in the 2.1% to 2.2% range.

Further out along the curve we see 10 year Australian government bond yields at around 2.78% as being slightly expensive. While Australia’s fiscal and monetary policy positions suggest our longer end can outperform the US, it is still vulnerable to any lift in US or offshore yields on a stronger growth outlook, upward revision to inflation expectations, reduction of central bank balance sheets or lift in term premia.

Views as at 28 February 2018.

February 2018

Market review

Global and domestic bond yields continued to rise over January as strong ongoing economic momentum led markets to reassess the timing and rate at which a number of central banks will remove high levels of monetary policy accommodation. Strong risk appetite, which supported equity markets and tighter credit spreads, reversed towards the end of the month on concerns that higher bond yields could eventually slow growth. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned -0.27% over January, with capital erosion from higher yields more than offsetting the income return.

At the shorter end of the yield curve, the three year Australian government bond yield rose to as high as 2.23% on stronger activity and labour force data, before a benign inflation reading drove a sharp late month rally. This saw the bond yield end the month 1 basis point (bps) higher at 2.14%. To a large extent, yields at the longer end of the curve took their cue from offshore moves, with the Australian 10 year government bond yield ending the month 18bps higher at 2.81%. United States, European and Japanese 10 year government yields ended the month 31bps, 27bps and 4bps higher at 2.71%, 0.7% and 0.09% respectively.

A deepening and broadening global recovery saw the International Monetary Fund (IMF) revise up their global growth forecasts for 2017 from 3.6% to 3.7%. Global growth forecasts for 2018 and 2019 were revised up 0.2 percentage points to 3.9% in both years. Much of the upward revision was attributed to the pro-cyclical impact of US tax policy, which the IMF estimates will boost US growth out to 2020. Growth in China is expected to moderate from 6.8% in 2017 to 6.6% in 2018 and 6.4% in 2019.

Domestic data readings suggest that the Australian economy finished 2017 on a firmer note in terms of activity, but price pressures remain subdued. Activity-based indicators remain buoyant with the CBA manufacturing and services PMIs lifting over December and pushing further into expansion territory. These trends were also reflected in the December NAB Business Survey, where both conditions and confidence rose, and capacity utilisation rates lifted to elevated levels. Also on the activity side, building approvals rose by an unexpectedly strong 11.7% in November on a sharp jump in apartment approvals.

Consumer sentiment and spending appear to have recovered from a mid-year slump. Retail sales surged 1.2% in November, significantly higher than expectations for a 0.4% gain, and followed a solid 0.5% gain in October. The improvement in consumer sentiment evident late last year looks to have carried over into January, with sentiment lifting to levels not seen since late 2013.

Labour market data continued to surprise on the upside, with total employment lifting by 34,700, well ahead of expectations for a 15,000 gain. The participation rate lifted to 65.7%, which is a level not seen since the height of the mining boom. This helped explain why the unemployment rate rose from 5.4% to 5.5%. Over the past year, total employment has grown by 3.4% and forward labour market indicators point to moderation over 2018.

December quarter consumer price data reinforced the picture of modest price pressures in the Australian economy and triggered a rally at the shorter end of the curve as markets reassessed the timing of the first Reserve Bank of Australia (RBA) tightening. Headline inflation rose by 0.6% over the quarter and 1.9% over the year. Underlying inflation, as measured by the average of the RBA’s statistical measures, gained 0.4% over the quarter and 1.9% over a year ago. Inflation excluding food and energy only gained 0.3% over the quarter.

Against this backdrop, money market yields eased with three and six month bank bills ending the month 2bps and 6bps lower at 1.78% and 1.93% respectively. Markets are fully pricing in the first tightening in early 2019, with the yield on the February 2019 30-day interbank cash rate futures contract ending the month at 1.79%.

Credit markets finished broadly unchanged, with the iTraxx Index ending January at 57bps. The banks hit the ground running with over $25bn of issuance in both international and domestic primary markets, which was met with strong demand and made good inroads into their funding tasks for the year. United Energy were the only non-bank to issue bonds in the domestic market, raising $400m in a dual tranche deal.

Market outlook

The lack of broader inflationary pressures evident in the latest Consumer Price Index release suggests that the RBA still has time to wait for evidence that stronger labour market conditions will eventually translate into higher wages and inflation.

We see the RBA as being firmly on hold for the time being and prepared to lag offshore central bank moves given that they had to ease monetary conditions more than in Australia. To the extent that such positioning leads to a lower exchange rate, this would be welcome by the RBA given that it has indicated that exchange rate strength makes it harder for it to achieve its growth and inflation forecasts.

Given RBA concerns about the medium-term risks to economic stability from the household sector taking on more debt relative to its income during a period of low rates, it appears to have little appetite for cutting the cash rate further.

We see the window for an initial burst of 50bps of tightening, which unwinds the 50bps of ‘emergency easing’ in mid-2016, as opening up later this year or early 2019. Thereafter, we look for the RBA to pause and follow up with another burst of 50bps of tightening over 2020/2021 if the growth and inflation outlook unfolds as expected. We suspect that against the backdrop of large stocks of debt being held by the household sector, the neutral cash rate sits around 2.7%, rather than the RBA’s estimated 3.5% level.

In our view, such a modest drawn-out tightening cycle is consistent with fair value for three year government bonds in the 2.1% to 2.2% range. At the longer end of the curve we see recent sell-off, which lifted the 10 year Australian government bond yield to 2.83%, taking them from being expensive to more fairly valued. We see near term risk that strong offshore growth, the pass through of higher oil prices into headline inflation rates and the risk of a lift in term premia, could push longer dated yields a little higher. However, we are mindful that structural factors, such as an ageing population, lower productivity growth and high levels of household debt, should limit the extent to which the cash rate can rise over the longer term.

Views as at 31 January 2018.

January 2017

Market review

The rally in Australian bond yields that began in late September came to an abrupt end in December as markets had to first digest a tightening in US monetary conditions and then an easing in US fiscal policy as the Trump administration passed its tax reform package. The passing of the latter helped support risk appetite over the month, with equity markets generally stronger and credit spreads tightening. Overall, the Australian bond market as measured by the Bloomberg AusBond Composite 0+ Yr Index, returned -0.52% over December, with capital erosion from higher yields more than offsetting the income return.

At the shorter end of the yield curve, stronger than expected labour force data was a factor behind the sharp lift in three year Australian government bond yields that ended the month 23bps higher at 2.13%. At the longer end of the curve, 10 year government bonds ended the month 13bps higher in yield at 2.63%. In contrast to the previous month, local yields rose by more than those in the US with the spread between Australian and US 10 year government bonds widening by 13bps to end the month at 22bps.

According to the latest national accounts, the Australian economy grew by 0.6% over the September quarter and by 2.8% over a year ago. The outcome was slightly weaker than markets were looking for and the drivers of growth over the quarter were a little uneven. Business investment was the largest positive contributor, adding 1 percentage points (pps) to the quarter’s growth rate, whilst stocks added 0.2pps and consumption only 0.1pps. There was a pullback in the public sector which detracted 0.4pps, whilst housing detracted 0.1pps and net exports were essentially flat. Drivers of growth were uneven on an expenditure basis, however on a state basis, growth became more even with Western Australia closing the gap to the other states.

Partial demand indicators suggest that momentum has carried over into the December quarter. Retail sales rose by a much stronger than expected 0.5% in October and points to a modest rebound in consumption. Consumer sentiment continued to recover with a solid lift in December attributed to receding concerns of an imminent rate hike cycle.

Activity based indicators remain buoyant with the CBA manufacturing and services PMIs lifting over November and pushing further into expansion territory. Whilst the NAB Business Survey recorded falls is in business conditions and confidence over November, overall levels remain very strong by historical standards and there was another solid lift in the capital expenditure component.

Labour market data surprised on the upside again and led markets to reassess the timing of the Reserve Bank of Australia’s (RBA) first monetary tightening. Total employment surged by 61,600, well ahead of expectations for a 19,000 gain. The composition of employment gains was strong with full time jobs up 41,900 against a 19,700 lift in part time jobs. Over the past year, employment has grown by 3.2% with construction and services sector jobs growth more than offsetting a large fall in manufacturing jobs as a number of car makers closed. Forward labour market indicators point to further moderate gains with both the ANZ Job Ads and DEWR Skilled Vacancies lifting over November.

Against this backdrop, money market yields lifted with 3 and 6 month bank bills ending the month 6bps and 8bps higher at 1.80% and 2.0% respectively. Markets have brought forward the timing for the first tightening from around mid-2019 to the end of 2018 with the yield on the December 2018 30-day interbank cash rate futures contract ending the month 11bps higher at 1.74%.

Credit markets ended 2017 on a strong note with the iTraxx Index closing the year at 58bps, a 7bps tightening over the month and 46bps contraction of the year. Throughout the year credit markets weathered the various geo-political events and were particularly buoyant as corporate fundamentals generally improved and we saw an increase in diversity of issuers as well as a lengthening in average tenor. Primary markets were subdued in December as issuers completed their funding tasks prior to the seasonally quiet year end period.

Market outlook

While in the US, the US Federal Reserve (Fed) and markets will have to grapple with the appropriate path for monetary policy after the Trump administration delivered a burst of fiscal stimulus, the latest fiscal update from the Australian government shouldn’t change the lay of the land too much for the RBA.

In its latest Mid-Year Economic and Fiscal Outlook (MYEFO), the government signalled a $9.3bn improvement in the underlying cash balance over the forward estimate period and a slight upgrade to the size of the projected 2020-21 Budget surplus from $7.4bn to $10.4bn. The key point for the RBA is that the update contained no “new” news, in that the average annual pace of fiscal consolidation at 0.6 per cent of GDP remains the same as that announced in the May Budget. Fiscal policy could come onto the RBA’s radar mid next year if the government follows through on its rhetoric and announces personal tax cuts.

Our view remains that the RBA is firmly on hold for the time being. Given RBA concerns about the medium-term risks to economic stability from the household sector taking on more debt relative to its income during a period of low rates, there appears to be a very high threshold to cutting rates further.

While the Governor has pointed out that the next move in the cash rate will be up, that move will not reflect the decisions of offshore central banks to remove accommodation, but domestic factors. In particular, the RBA will be looking for signs that stronger conditions in the economy and labour markets are feeding into higher wages growth and inflation.

We still see the upcoming tightening cycle as being modest and drawn-out by historical standards and most likely to commence late 2018/early 2019. The recent sell-off at the shorter end of the yield has taken 3 year Australian government bonds from being expensive to fairly valued.

Although yields have risen at the longer end of the curve, we continue to regard the yield on a 10 year Australian government bond at 2.63% as being at the expensive end of our fair value ranges. While we accept that structural factors should limit the extent to which longer-dated yields can rise, investors also need some compensation for the risk that given current pro-cyclical policy settings, inflation may turn out to be higher than expected over the coming years. Furthermore, as central banks begin to taper their asset purchase programs and/or reduce the size of their balance sheets, a force holding down yields at the longer end will be subsiding.

Views as at 31 December 2017.

December 2017

Market review

The rally in Australian bond yields that began in late September continued over November as circumspect central bank commentary and mixed prices and activity data led markets to push back the timing of the first tightening further into 2019. US tax plan uncertainty triggered a mid-month widening in credit spreads and weakness in equity markets, which later unwound as risk appetite recovered. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.87% over November, with capital gains adding to the income return. Sector returns over the last two months have been particularly strong, with the Bloomberg AusBond Composite 0+ Yr Index up 1.97%.

At the shorter end of the yield curve, 3 year Australian government bond yields ended the month 8 basis points (bps) lower at 1.90% as markets took the view that the mix of data, in particular a weaker than expected lift in wages, meant that the Reserve Bank of Australia (RBA) could delay monetary tightening until mid-2019. At the longer end of the curve, 10 year government bond yields ended the month 17bps lower in yield at 2.50%. Australian yields outperformed those in the US, where markets continue to factor in modest tightening by the US Federal Reserve (Fed). US 2 year Treasuries rose by 19bps to end the month at 1.79%, while US 10 year Treasuries ended the month 3bps higher at 2.41%. The spread between Australian and US 10 year government bonds narrowed by 20bps to end the month at a very narrow 9bps.

There was some unevenness in domestic data readings over the month. On the softer side was September retail sales data which came in flat against expectations for a 0.4% lift. Real retail sales rose by only 0.1% over the quarter, pointing to sluggish consumption growth in the upcoming September quarter national accounts. Also on the weaker side was the 0.5% lift in the September quarter wage price index. Given that the 3.3% lift in the minimum wage flowed through to awards during the quarter, the result was indicative of wage softness in non-award wages, consistent with the view that there is still some slack in labour markets. Consumers remain in a cautious mind-set, with sentiment slipping back again November.

In contrast, activity based indicators remain relatively buoyant. Business conditions in the October NAB Business Survey rose to the highest levels ever recorded and capital expenditure plans continued to rise. Firming investment intentions were also evident in the 1% lift in new private capital expenditure over the September quarter. Housing activity data was also on the stronger side of expectations with both September and October data surprising on the upside, with ongoing strength in detached dwelling approvals more than offsetting a modest easing in apartment approvals.

After a very strong period, the rate of jobs growth eased back in October. While total employment rose by only 3,700, the trend of rising full time jobs evident this year continued. Full time jobs rose by 24,300, while part time jobs fell 20,700. A slight fall in the participation rate resulted in the unemployment rate edging down to 5.4%. Forward labour market indicators point to further moderate gains with both the ANZ Job Ads and DEWR Skilled Vacancies lifting over October.

Against this backdrop, markets focused more on the weaker activity and prices data and pushed back their tightening expectations further into 2019. The yield on the December 2018 30-day interbank cash rate futures contract ended the month 7.5bps lower at 1.63% against the current cash rate of 1.5%. The March 2019 contract ended the month 5.5bps lower at 1.71%.

As measured by the iTraxx Index, domestic credit markets recovered from the mid-month volatility seen in US high yield markets and ended the month broadly unchanged at +65bps. Primary markets were buoyant as issuers looked to finalise their debt funding tasks for 2017 prior to end of the year where activity typically declines. During the month we had the inaugural bond deal from Endeavour Energy which followed fellow NSW energy company, Ausgrid, which debuted into the domestic market last month.

Market outlook

In its latest Statement on Monetary Policy (SOMP) the RBA’s base case for the growth outlook was little changed from its August forecast run. While they expect the rate of growth to ease slightly in the upcoming September national accounts, their broader narrative remains similar. They see the drag to growth from falling mining investment ending and for public demand and recovering non-mining business investment to help lift economic growth from 2.5% in 2017 to 3.25% in 2018 and 2019.

While above trend growth is expected over 2018 and 2019, they note that it will take some time for the economy to encounter broad-based capacity constraints. Uncertainty about the translation of tightening labour market conditions into wages and ultimately inflation was reflected in a downgrade to their inflation forecasts. Underlying inflation is now only expected to reach 2% mid 2019, compared to 2.5% in the August SOMP.

Given RBA concerns about the medium-term risks to economic stability from the household sector taking on more debt relative to its income, there appears to be a very high threshold to cutting rates further. While the Governor has pointed out that the next move in the cash rate will be up if the economy grows as expected, spare capacity will have to be used up before that can happen.

We still see the upcoming tightening cycle as being modest and drawn-out by historical standards, with the risks tilted slightly towards the RBA starting the cycle in early 2019 rather than late 2018. We suspect that markets have gone a little too far in pushing back tightening into mid 2019, given that the RBA may choose to commence removing policy accommodation on financial cycle grounds. Furthermore, with the Fed expected to tighten in December and further over 2018, there is scope for the currency to depreciate and provide a pro-cyclical pulse to the economy that brings tightening forward.

Views as at 30 November 2017.

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This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited (AFSL 444266, ABN 16 165 119 531). The information herein shall not in any way constitute advice or an invitation to invest. It is solely for information purposes and subject to change without notice. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. Past performance is not indicative of future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

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