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

Market review

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.

Market outlook

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.