Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Fiscal and prospective conventional and unconventional monetary easing helped buffer Australian asset markets from rising volatility caused by a COVID-19 resurgence in the Northern hemisphere and upcoming US election. The Australian equity market outperformed offshore markets, credit spreads continued to narrow and there was a modest lift in inflation expectations. Australian government bond yields fell at the shorter end of the yield curve, while longer-dated yields edged higher. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, ended October 0.28% higher.
Easing is most likely to take the form of a cut in the cash rate, three-year government bond yield target and TFF rate by 15bps from 0.25% to 0.10%.
Yields at the shorter end of the Australian government yield curve rallied following a seminal mid-month speech by the Reserve Bank of Australia (RBA) Governor in which the RBA updated its reaction function to include a greater emphasis on full employment and shift from targeting expected inflation to actual inflation. The three-year government bond yield ended the month 4 basis points (bps) lower at 0.12%.
Longer-dated government bond yields were very volatile and traded the month in a 17bps range. The 10-year government bond yield rose to as high as 90bps before rallying to as low as 72bps following the RBA Governor’s speech, which also raised the prospect of an asset purchase program. Yields then rose from their lows, with the 10-year government bond yield ending 4bps higher at 0.83%, while the 30-year government bond ended 8bps higher at 1.80%.
The brightest economic news was the gradual release of the Victorian economy from severe lockdown measures, which had been a drag on national growth. Retail sales fell by 4% in August, while employment dropped by 29,500 in September and the unemployment rate edged up to 6.9%.
There were also signs of policy support working with business conditions and confidence improving in the September NAB Business Survey. The Budget appears to have been well received, with consumer confidence bouncing strongly in October. There was also a lift in prices, with the unwinding of childcare support and working from home-related spending pushing the Consumer Price Index up 1.6% over the September quarter and lifting the yearly rate to 0.7%. Core inflation remained subdued, with the average of the RBA statistical measures lifting by 0.4% over the quarter for a 1.2% yearly rate.
Money market rates moved to factor in an imminent easing in monetary conditions. Three-month bank bills ended the month 3bps lower at 6bps, while six-month bank bills ended 5.5bps lower at 6.5bps. The December 30-day cash futures contract fell from 8bps to 4.5bps, with markets factoring in a 3bps cash rate at the end of 2021.
Despite jitters offshore, Australian credit markets regained their mojo with the iTraxx Index tightening 6bps to 70bps and corporate bond spreads rallying 8bps, generating healthy returns for credit investors. With the initial allocation of the Term Fund Facility (TFF) fully drawn upon by domestic banks, and three of the major banks passing their September reporting balance dates, there was strong demand for credit across the spectrum. Appetite was further fuelled by the prospect of imminent easing measures from the RBA, which saw senior bank note spreads tighten 9bps to their lowest level since before the Global Financial Crisis in 2007. All maturities up to five years were trading inside 30bps at the time of writing.
Primary markets remained active, with non-bank Residential Mortgage Backed Securities (RMBS) issuers and offshore banks filling the void in supply left behind by the domestic banks. Challenger, Bank of Queensland and Bendigo & Adelaide Bank all use the firmer conditions to launch smaller hybrid deals, the former two were refinance deals delayed from earlier in the year. Corporate issuers were also active, with an inaugural deal from Charter Hall for their Prime Industrial Fund and annual issuance from Port of Melbourne seeing continued strong investor demand.
Australian policy remains highly accommodative, with the October Federal Budget pivoting fiscal policy from playing a ‘support’ role to a ‘rebuilding’ role. The widening in the budget deficit to $213.7bn or 11% of GDP in 2020-21 provides a strong positive fiscal pulse at a time when the economy needs help in recovering from the damage caused by the COVID-19 lockdown measures.
While the Reserve Bank of Australia (RBA) held off moving in October to allow fiscal policy to take centre stage, we see a slightly better than expected inflation outcome, the RBA calling a positive quarter of growth in Q3 and the opening up of the Victorian economy, as no barrier to a November easing.
Easing is most likely to take the form of a cut in the cash rate, three-year government bond yield target and TFF rate by 15bps from 0.25% to 0.10%. Negative rates remain highly unlikely and we believe the door remains wide open to the RBA extending its Quantitative Easing (QE) program to include a Large-Scale Asset Purchase Program (LSAP) targeting government and semi-government bonds in the five- to 10-year part of the yield curve.
Greater use of its balance sheet would help it meet its revised reaction function, where the RBA placed a stronger emphasis on reaching full employment and targeting actual, rather than expected inflation. A LSAP targeting the five- to 10-year part of the curve would help support jobs growth by lowering the term structure and economy-wide borrowing rates at a time when Federal and State governments are borrowing heavily.
We still regard cyclical and structural factors as pointing to many years of ultra-low cash rates and remain attracted to duration while the yield curve is positively sloped. We see periods of excessive curve steepening as opportunities.
Despite ever-present solvency risks, we expect spread sectors to be shored up by the outlook for an extended period of low yields on government securities, unprecedented levels of central bank support for both sovereign and non-sovereign debt markets and investor demand for income.
We remain mindful that massive fiscal easing, burgeoning money supplies, geo-strategic supply chain reconfigurations and the blurring between monetary and fiscal policy in some jurisdictions raises medium to longer term inflation risks. Against this mix of cyclical and structural factors, we think it remains prudent to hold a modest core exposure to inflation-protected securities while inflation protection remains relatively cheap.
Views as at 31 October 2020.