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

Market review

Australian government bond yields fell sharply, benefitting from a watering down of tightening expectations at the shorter end of the yield curve and flight-to-quality flows at the longer end. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.5% over December.

The economy expanded by a less than expected 0.3% over the September quarter and led to some pushing back of tightening expectations early in the month. These briefly unwound, only to resume again as a strong rally in US yields, driven by a more dovish view of the US Federal Reserve (Fed) and flight-to-quality flows from the sell-off in equity and credit markets, dragged global and domestic yields lower.

US two and 10 year government bond yields both fell by 30 basis points (bps) to end the month at 2.49% and 2.68%. Australian government bond yields moved in sympathy, though there was more curve flattening evident in our market. The three year government bond yield ended the month 16 basis points (bps) lower at 1.85%, while the ten year government bond ended 27bps lower at 2.32% (levels not seen since late 2016).

In other domestic data readings, both the CBA Composite PMI and business conditions in the NAB Survey pointed to solid activity levels in November. Retail sales lifted by an expected 0.3% in October, while consumer sentiment held onto November’s strong lift despite further falls in house prices and volatility in financial markets.

Labour market conditions remained solid. The total number of jobs rose by 37,000 over November, though the ‘quality’ of job gains was down on previous months, with part time jobs up by 43,400 while the number of full time jobs fell by 6,400. That said, a lift in the participation rate to 65.7%, just shy of cyclical highs, was a positive development. With not all new entrants gaining work, there was a slight lift in the unemployment rate from 5.0% to 5.1%.

There was also some evidence that tightening labour market conditions were translating into higher wages. In September quarter Enterprise bargaining data, the average annualised wage increase per employee for deals struck in the quarter rose to 3.2%, well up from the 2.2% rate a year ago.

Despite partial demand indicators pointing to a stronger performance from the real economy over the December quarter, concerns that falling asset prices and weaker offshore growth could slow the economy going forward led markets to reassess their expectations for the likely path of the Reserve Bank of Australia (RBA) cash rate. Markets have moved from pricing in a 40% chance of a tightening by the end of 2019 a month ago, to pricing in around a 40% chance of a rate cut. There was a tightening in liquidity conditions in money markets which saw three and six month bank bill yields end the month 14bps and 9bps higher at 2.09% and 2.22%, respectively.

The negative sentiment experienced in equity markets also impacted credit markets, with the iTraxx Index widening 8bps to finish the month at 95bps. Primary markets were extremely quiet as this negative sentiment, coupled with the generally quieter end of calendar year, meant that most borrowers sat on the side lines either having pre-funded their borrowing obligations earlier in the year or being content to wait to see how market conditions develop early in 2019.

Market outlook

A gap has opened up between the markets and the RBA’s expectations for the path of the cash rate. While markets are now pricing in a 40% chance of an easing late 2019 to mid-2020, the RBA reiterated its view in the December Monetary Policy Meeting minutes that the next move in rates was most likely to be up rather than down and that there was no strong case for a near term move.

In assessing whether the recent rally is based on fundamentals rather than sentiment, or a mixture of both, it’s worth reviewing the RBA’s base case view and whether it is finding support in the data. Their expectations are for a period of above trend growth that incrementally absorbs remaining labour market slack and leads to a gradual lift in wages that will be reflected in a lift in underlying inflation to around 2.25% by the end of 2019. Such a view did get some support in the September quarter Enterprise bargaining data and the NAB Survey is consistent with near term monthly jobs gains of around 20,000 and enough to keep the unemployment rate trending lower. Furthermore, improvement in the fiscal position is reflective of stronger labour market conditions and a rebound in the nominal income side of the economy.

We still hold on to our view that the RBA will be in a position to gradually remove policy accommodation and have responded to recent developments by pushing back the timing of the first tightening into the first half of 2020. Thereafter we look for a gradual and drawn-out removal of policy accommodation that eventually returns the cash rate to 2.50% by 2022. We see this rate as being close to the economy’s neutral rate given the added grip that monetary policy has at time of high household debt levels.

Markets beginning to factor in monetary easing seem premature given the prospect of fiscal easing in an election year, a large pipeline of public infrastructure spending and support from a lower exchange rate. Macro-prudential measures were again eased, with the Australian Prudential Regulation Authority (APRA) lifting restrictions on interest only lending. This comes on top of their April move to remove the “speed limit” on investor lending and in aggregate should remove a source of downside pressure on housing prices.

At the time of writing, three and 10 year government bonds were yielding 1.8% and 2.29%, respectively. Both appear expensive, heavily discounting the downside risks to the growth and inflation outlook rather than the most likely path given current policy settings.

Views as at 31 December 2018.