Jay Sivapalan, Head of Australian Fixed Interest, discusses the significant shifts in 2016 that impacted the investment landscape and how higher bond yields could help restore the legitimacy of the asset class as a defensive asset.

The Australian fixed interest market changed significantly over the course of 2016 and while the election of Donald Trump has clearly played a role, we believe many of the changes were already well underway prior to his election.

Has the bull run its course?

We now believe that the 30 year bull market in bonds is likely over, meaning interest rates and bond yields in the developed world will potentially trend higher in the coming years.

Looking at recent developments, there is growing acceptance that monetary policy has done all it can to help economies recover and driving interest rates lower is no longer the answer. With global growth still relatively subdued, focus has shifted towards the need for greater use of fiscal policy to sustain global recovery.

There is clearly uncertainty around how this will ultimately unfold, especially given the changing political landscape where populist governments are seemingly more inclined to pursue fiscal stimulus initiatives.

We expect increased volatility in financial markets over the coming year, which carries with it the potential for markets to move further than consensus thinking would contemplate. This is particularly relevant in managing fixed interest portfolios in a rising yield environment.

How high can yields rise?

We believe bond yields will be on a gradually rising trend over the next few years as central banks pare back the extreme levels of monetary stimulus applied during the post-Global Financial Crisis era. That said, the scope for central banks to lift cash rates will be much less than in the past because of the structural factors that will continue to constrain economic growth in the years ahead.

There is a common misconception that changes in the Reserve Bank of Australia (RBA) cash rate correspond to changes in long term bond yields. Bond markets are actually pre-emptive and long term yields typically move well in advance of changes in the cash rate – effectively a leading indicator of future changes in monetary policy. However, bond markets do not always get it right and we believe that increases in bond yields will only be sustained if they correctly reflect expectations about future changes in monetary policy.

Looking back at some recent episodes in Australia, where bond yields have risen substantially, can offer some insight in relation to how the current cycle may unfold.

Chart 1: 10 year Australian Government Bond yield versus RBA cash rate

[caption id=”attachment_225256″ align=”alignnone” width=”680″] Source: Bloomberg, monthly to 1 January 2017.[/caption]

1. Looking first at the period from late 2008 to mid-2009, the 10 year Australian Government Bond yield rose over 150 basis points (bps), mostly ahead of any increase in the RBA cash rate, highlighting the pre-emptive nature of bond markets. In this cycle, the market was broadly correct in predicting the subsequent tightening of monetary policy which saw the cash rate rise by 175bps, from 3.00% to 4.75%.
2. Looking next at the period during 2013, the 10 year Australian Government Bond yield rose by around 125bps. This episode was driven by fears that the US Federal Reserve was going to wind back its Quantitative Easing program, commonly referred to as the ‘Taper Tantrum’. In this cycle, the bond market incorrectly predicted that 2.50% would mark the end of the easing cycle in Australia, whereas the official cash rate subsequently fell to its current level of 1.50% following a long period of stability. In this case, bond yields resumed their decline as market expectations about future moves in cash rates changed.

With this background, we believe the market is correct in pricing out further monetary easing, and general consensus is that monetary policy has reached the limits of its ability to stimulate the economy.

However, unlike the cycle in 2009, we do not expect the RBA to be in a position to begin raising the cash rate for quite some time, possibly for as long as 18 months to two years and we do not dismiss the potential for it to fall further.

If correct, we believe it will be very difficult for Australian bond yields to rise too much further (at least over the next couple of years). This view also recognises that the neutral cash rate in Australia is around 2.50% to 3.00%, which means the next peak in the RBA cash rate will be much lower than ever before.

Higher bond yields’ silver lining

While higher bond yields may be seen as detrimental in the short term, the record low levels that bond yields reached had raised legitimate concerns about the relevance of the fixed interest asset class. Higher bond yields will help to restore the defensive attributes that fixed interest assets can provide to a balanced investment portfolio and ultimately create the opportunity for improved returns.