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

Market review

The strong performance of global bond markets continued over July, with returns boosted from a further decline in yields and narrowing in credit margins. The search for yield continued to underpin exceptionally strong demand for credit investments, with bid to cover ratios for primary issuance at extremely elevated levels. Domestically, the Reserve Bank of Australia (RBA) followed up June’s rate cut with another 25 basis point (bps) cut, taking the official cash rate down to 1%. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.95%, with price appreciation from lower yield and tighter spreads boosting the income return.

Following the widely expected move by the RBA and better than expected US inflation data, three and 10 year Australian government bond yields rose to as high as 1% and 1.45% mid-month. Yields subsequently rallied as offshore central banks became increasingly dovish with the US Federal Reserve (Fed) cutting the Fed funds rate by 0.25% at the end of the month. The rally over the second half of the month saw three and 10 year Australian government bonds end the month 15bps and 14bps lower, hitting historical lows of 0.82% and 1.18%, respectively.

Money market yields reacted to the RBA move and offshore developments by discounting further monetary easing. Three and six month bank bill yields fell by 20bps and 19bps to end the month at 1.01% and 1.03%, respectively. Markets are now fully pricing in a 0.75% cash rate by November 2019 and a 0.5% cash rate mid-2020.

Credit markets ended slightly stronger, with the iTraxx Index closing 4bps tighter at 59bps. During the month, APRA finalised its approach to loss absorbing capacity for the domestic major banks and announced that an additional 3% of capital was required and this was to be funded via existing capital instruments. Major banks subsequently announced their intention to meet this requirement by issuing subordinated bonds. Westpac and ANZ hit the ground running with large deals in the USD and AUD markets, respectively. This additional issuance of subordinated debt means a lower supply of senior unsecured bonds over time and this dynamic saw the credit spreads of these securities rally meaningfully over the month.

Economic data readings were on the sluggish side, with retail sales lifting by only 0.1% in May. Despite RBA rate cuts and the prospect of near-term tax breaks, consumer sentiment fell in July. According to the NAB survey, there was a modest lift in business conditions though these remain slightly below longer run levels.

Labour market conditions cooled, with total employment lifting by 500 jobs. The composition of this gain was on the encouraging side however, with full time jobs up by 21,100 and part time jobs down by 20,600. The participation rate remained at a historically high level of 66%. The employment component of the June NAB survey is consistent with near-term job gains of around 20,000 per month, which should be sufficient to keep the unemployment rate at or slightly below current levels.

On the prices side of the economy, the headline inflation rate lifted by a stronger than expect 0.6% over the March quarter, lifting the yearly rate from 1.3% to 1.6%. Underlying inflation remains subdued, with the average of the RBA’s statistical measures lifting by 0.4%, for a yearly rate of 1.4%.

Market outlook

Offshore central banks and Chinese policy makers appear to be responding to the current configuration of subdued inflation and trade and Brexit uncertainty by signalling moves towards more accommodative policy stances.

In Europe, Mario Draghi, the European Central Bank President, expressed dissatisfaction with the growth and inflation outlook and raised market expectations for an easing package at its September meeting. In China, the Politburo noted that downside risks had increased and the need to keep liquidity appropriate and abundant. They ruled out using property as a short term stimulus, preferring to support demand via reforms to expand consumption. In the US, the Fed delivered a precautionary 25bps cut in the Fed funds rate, casting the move more in a risk management light rather than as the start of an extended easing cycle.

Against this backdrop, the RBA cut the cash rate by 25bps in both June and July noting that these moves would make further inroads into spare capacity and assist with faster and more assured progress towards its inflation target.

We initially thought the RBA would pause while it waited to see how the economy would respond to:

• 50bps of easing (cash rate cut from 1.5% to 1%);
• the first tranche of tax relief worth 0.5% of GDP (similar impact to two rate cuts);
• bringing forward of smaller ‘shovel-ready’ infrastructure projects;
• relaxation in macro prudential policies related to residential lending;
• a potential rebound in consumer sentiment associated with a plateau/lift in house prices;
• a 3% lift in the minimum wage (up around 10% over the last 3 years); and
• the removal of pre-election policy uncertainty.

However, we have modified our base case forecasts following the RBA Governor’s speech on ‘Inflation Targeting and Economic Welfare’. In that speech, the Governor noted that while Australia’s fundamentals were strong and that complementary policy measures should boost demand, the RBA stood ready to provide additional policy support if needed. Even if easing was not required, the Governor stated that it was “reasonable to expect an extended period of low interest rates” and that rates would not move up until the RBA were confident that inflation would return to around the midpoint of its target range.

We now look for a further cut in the cash rate before the end of the year and have pushed back the timing of the first tightening into 2022. We see the balance of risks tilted to the low side in the near-term and agree with the Governor that fiscal policy, not monetary policy, is best suited to dealing with any significant demand shocks.

Accordingly, we see three year Australian government bond yields at around 82bps at the time of writing as being towards the expensive end of our fair value band. Even after allowing for our lower cash rate projections and downward revisions to our longer term neutral cash rate estimates, we struggle to see any value in long term yields at prevailing levels. Term premia remain extraordinarily depressed and break-even inflation rates very low for an open economy with a floating exchange rate and accommodative policy settings. More broadly, if monetary policy cannot boost demand from here, there is the risk that unconventional and untried measures may be used here or offshore and bring with them the risk of higher inflation in the future.

Views as at 31 July 2019.