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