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

Market review

Australian government bond yields rallied at the shorter end of the yield curve as markets continued to bring forward the timing of monetary easing. Yields at the longer end of the curve gave back earlier gains to end the month largely unchanged. Supportive policy settings and signs that the deceleration in global and domestic growth evident late 2018 had passed helped support risk appetite. Equity markets were firmer and there was further tightening in credit spreads. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.28%, primarily reflecting the income return.

Partial demand indicators improved over the month, with three and 10 year government bond yields lifting to as high as 1.49% and 1.96% before the release of the March quarter Consumer Price Index (CPI) towards the end of the month. Building approvals and retail trade data for February came in well-ahead of expectations, with approvals up 19.1% over the month and retail trade up 0.8%. According to the NAB Survey, business conditions lifted from below trend to around trend levels in March.

The Federal Budget and prospect of further fiscal easing in the upcoming Federal election helped lift consumer sentiment in April back towards longer run levels. The run of strong trade data continued, with the trade surplus lifting from $4.3bn in January to $4.5bn in February. These data are consistent with a pick-up in the pace of growth from the weak levels prevailing over the second half of 2018.

Labour market conditions remained solid. Employment grew by a stronger than expected 25,700 in March, with the number of full time jobs surging by 48,300. Part time jobs fell by 22,600 and a slight lift in the participation rate back towards cyclical highs meant that the unemployment rate edged back up to 5%. Forward labour demand indicators are mixed, but still consistent with job gains sufficient to hold the unemployment rate steady to slightly lower.

It was the release of weaker than expected consumer price data that triggered a late month rally and saw markets bring forward the timing of the first easing. While a low headline rate was expected because of earlier falls in fuel prices, the 0.2% lift in the average of the Reserve Bank of Australia’s (RBA) statistical or core measures was well-below expectations. The yearly core rate slipped from 1.7% to 1.4% and triggered one of the RBA conditions for easing, the other being sustained weakening in the labour market.

Yields rallied from mid-month highs following the CPI release and markets went as far as pricing in around a 50% chance of a rate cut in May. The three year government bond yield ended the month 11 basis points (bps) lower at 1.28% while the 10 year government bond yield closed 1bps higher at 1.79%.

Money market yields reflected the bringing forward of easing expectations, with three and six month bank bill yields falling by 21bps and 22bps to end the month at 1.56% and 1.62%. Markets are fully pricing in an easing in July with a 1% cash rate priced in by November. By mid-2020, markets are assigning around a 20% chance of a 0.75% cash rate.

Credit benefitted from the ‘risk-on’ tone this month as investors searched for yield in an environment where inflation is sluggish and central banks are looking to maintain or increase accommodative policy settings. The iTraxx Index tightened 9bps to close at 66bps which is towards the lower end of historical outcomes. The highlight in primary markets was Woolworths issuing the world’s first green bond by a supermarket retailer. The demand for this bond by domestic investors was significant, with the company printing $400m of new bonds to around $2bn of investor demand.

Market outlook

We see information in the March quarter CPI release that justifies a shift in our base view from a ‘steady for longer’ scenario for the cash rate to one where the RBA needs to provide the economy with a further burst of easing on top of a 0.5% of GDP boost coming from tax cuts starting from the beginning of July.

While in the latest set of minutes the RBA noted that it was not possible to fine-tune outcomes and that by holding policy steady it would be a source of stability and confidence, they also noted that in a scenario where inflation did not move higher and the unemployment rate trended up it would be appropriate to ease in those circumstances.

We see the weak 0.3% lift in non-tradeables inflation and fall in the yearly rate from 2.4% to 1.8% as indicative of a combination of remaining slack in the economy and competitive pressures. The RBA will have to revise its inflation outlook lower in its upcoming May Statement on Monetary Policy and balance a situation where one of its two preconditions for easing has been triggered.

We suspect that the RBA will move to an explicit easing bias in May but will have cut the cash rate to 1% by November, judging that it would be in the public interest to ensure that inflation returned to the target band and that inflation expectations did not become unanchored.

Our view is that while monetary conditions are already accommodative, the combination of a further burst of monetary easing, easier fiscal conditions and possibly a lower exchange rate, will help support activity and speed up the rate of absorption of spare capacity. While markets see the prospect of further easing in 2020, we suspect that 1% will be the low in the cash rate and that the RBA, like the US Federal Reserve, will seek to normalise the cash rate as soon as conditions allow.

We currently see three year government bond yields at 1.27% (at the time of writing) as being towards the expensive end of our fair value range. There is scope for a nearer term lift if markets wind back the amount of easing currently priced in, but the prospect for any significant rise is limited given that there is still slack in the economy. Further out along the yield curve, we see the yield on a 10 year government bond of 1.78% (at the time of writing) as being modestly expensive and vulnerable to any upward revision to global growth or inflation expectations.

Views as at 30 April 2019.