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

Market review

Australian government bond yields continued to rally as the Reserve Bank of Australia (RBA) cut the cash rate and major offshore central banks signalled more policy support to provide an offset to ongoing trade tensions if needed. Sentiment shifted from ‘risk-off’ to ‘risk-on’, with equity markets performing strongly and credit spreads narrowing as investor searched for yield. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.04%, with price appreciation from lower yields boosting the income return.

After laying the ground work for monetary easing on the view that the economy had spare capacity, the RBA followed up by cutting the cash rate from 1.5% to 1.25% early in the month. The previous burst of easing was a 50 basis point (bps) move between May and August 2016. Following the move, the RBA Governor noted that the decision was about making further inroads into the spare capacity in the economy and assisting with “faster progress in reducing unemployment and achieving more assured progress towards the inflation target”. Subsequent commentary was consistent with a near-term follow up move.

Against this backdrop and dovish commentary from the US Federal Reserve (Fed) and the European Central Bank (ECB), three and 10 year government bond yields both ended the month 14bps lower at 0.96% and 1.32%, respectively.

Money market yields reacted to the RBA move by bringing forward the timing of the next cut to August with a high chance of a July move. Three and six month bank bill yields fell by 21bps and 20bps to end the month at 1.21% and 1.22%, respectively. Markets are now fully pricing in a 0.75% cash rate by February 2020 and assigning around 70% chance of a 0.5% cash rate mid-2020.

The Australian economy put in a third quarter in a row of sub-trend growth, recording growth of only 0.4% over the March quarter and 1.8% over a year ago. Dwelling investment and stocks detracted from growth. Consumption, business investment, the public sector and net exports made small positive contributions.

While output measures remain subdued, labour conditions continue to hold up. Employment rose by a stronger than expected 42,300 over May but a lift in the participation rate to a record high of 66% meant that the unemployment rate remained unchanged at 5.2%. This rate remains well above the RBA’s 4.5% long-run sustainable rate, and indicative of further slack.

Forward labour market indicators point to a moderation in labour demand, with the May NAB Business Survey consistent with employment growth of around 18,000 per month, a rate consistent with mild improvement in the unemployment rate.

There was early evidence of a possible lift in activity post the Coalitions unexpected election win, with the preliminary June CBA Manufacturing and Services PMIs lifting further into expansion territory. Business conditions in the earlier May NAB Business Survey were more subdued with cost pressures weighing on profitability.

The ‘risk-on’ sentiment seen in global markets extended to the domestic credit market with the iTraxx Index finishing June 15bps tighter, at a spread of 63bps. Credit investors reacted positively to the signal of further monetary stimulus from the Fed and ECB, as well as the reduction in official interest rates by the RBA. Primary market activity however, was relatively subdued. One notable highlight was the ANZ bank that issued a new RMBS security. The $1.5bn deal was the first RMBS bond issued by the company since late 2016 and was met with strong demand.

Market outlook

While major global central banks have responded to the uncertainty created by trade tensions by signalling further policy accommodation, the latest move by the RBA primarily reflected more domestic concerns.

These centred on cumulative evidence that the economy still had some spare capacity. In the words of the RBA Governor, the cut in the cash rate from 1.5% to 1.25% in early June was “not in response to a deterioration in the economic outlook”…but “reflected a judgement that we could do better than the path we looked to be on”.

We look for another rate cut in July/August and thereafter expect a period of stability as the RBA waits to see how the economy responds to:

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

While less controllable, a return to more seasonal conditions would also provide a boost to the economy, as would prolonged weakness in the exchange rate.

Although another easing is possible late this year or early next year, it would need the economy to not respond to considerable stimulus and would also need to pass the RBA’s welfare test. A move below 1% may disproportionately hurt savers, lead to a surge in borrowing and increase the risk of capital being misallocated as investors search for higher yielding alternatives. It is on this basis that we anticipate growing resistance to the cash rate moving too far below 1.0%. As the RBA Governor has reiterated, fiscal policy is far better equipped to support aggregate demand at this juncture.

We see the shorter end of the curve, where markets are assigning a 70% probability to a 0.50% cash rate mid-2020 being moderately expensive, and assigning little probability to the economy responding to the complementary policy push it is receiving. We think there is reasonable scope for markets to reassess the amount of easing needed over the second half of the year, which if this were to eventuate, would lead to a modest increase in shorter-term bond yields.

Long-term yields look increasingly over-valued on a range of valuation metrics that we use. Real yields, term premium and break-even inflation rates are around historic lows. A key aspect of our investment approach is that markets are prone to overshoot fundamental value as temporary influences are disproportionately reflected in the valuation of long-term securities. While this only ever becomes evident in hindsight, we feel the current environment is displaying characteristics of this. We do not discount the possibility of yields moving even lower but beyond the short term anticipate a meaningful lift in longer-term yields as policy initiatives foster an improvement in growth and a lift in actual and expected of inflation.

Views as at 30 June 2019.