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

Market review

Australian government bond yields initially followed offshore yields higher following the recommencement of high level trade talks between the US and China and an easing in global policy settings. However, geo-political events, along with sluggish domestic data and dovish commentary from the Reserve Bank of Australia (RBA), saw yields fall over the latter part of the month. While the shift in sentiment to ‘risk-on’ supported equity markets, credit markets were steadier. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell for the first time in 11 months by 0.49%, with price depreciation from modestly higher yields offsetting the income return.

Three and 10 year government bond yields rose to their mid-month highs of 0.91% and 1.19% following perceptions of progress on the trade front and policy easing in Europe which included the prospect of fiscal easing in Germany. The European Central Bank (ECB) reintroduced quantitative easing at a €20bn a month pace from November and lowered the deposit facility rate by 10 basis points (bps) to -0.50%. Forward guidance also became more open ended with accommodation not ending until the inflation outlook robustly converged towards the ECB’s target.

Sentiment shifted to ‘risk off’ following the attack on Saudi oil refineries with offshore and domestic yields benefitting from ‘flight to quality’ flows as geo-political risk rose. Yields continued to fall following the US Federal Reserves’ (Fed) decision to lower the US cash rate by 25bps, even though the Fed’s dot plots indicated no further cuts.

Comments from the Reserve Bank Governor towards the end of the month that “further monetary easing may well be required” maintained downward momentum on shorter dated yields and raised expectations for an October rate cut. Nevertheless, the fall in yields was not enough to completely offset earlier rises, with Australian three and 10 year government bond yields ending the month 7bps and 13bps higher at 0.74% and 1.02%.

Key economic releases over the month were the June quarter national accounts and August labour force data. While the headlines of 0.5% GDP growth and jobs of growth of 34,700 looked solid, underlying details were softer and indicative of a lack of private demand and remaining labour market slack.

Partial demand indicators have yet to show signs of responding to earlier rate cuts and fiscal stimulus. Retail sales fell 0.1% in July, while consumer sentiment fell in September. Business conditions fell modestly in August according to the NAB survey and remain below longer run levels. Forward labour market indicators point to a moderation in labour demand with job vacancies falling 1.9% in the August quarter. While the CoreLogic Home Value Index lifted by 1% in August, credit demand remains subdued with private sector credit up by a less than expected 0.2% in August with the yearly rate drifting down to 2.9%.

On the back of offshore developments and dovish RBA signalling, markets are assigning a 75% chance of a cut in the cash rate to 0.75% in October and fully discounting a 0.75% cash rate by November. Markets have a 0.50% cash rate factored in by May 2020 and around a 20% chance of a 0.25% cash rate by August 2020. Three month bank bill yields ended the month 2bps lower at 0.95%, while six month bank bill yields ended 6bps higher at 1.05%.

The improvement in risk appetite that supported equity markets saw credit markets stabilise during the month. Derivative markets outperformed, with iTraxx rallying 5bps (adjusting for the contract roll), while high grade corporate cash spreads were largely unchanged finishing 1bp wider on the month.

Issuers took the opportunity of more stable market conditions and ongoing demand from investors, to issue A$9.5bn during September. A number of global banks issued bonds into the Australian market but the largest deal was offered by Macquarie via their PUMA residential mortgage-backed security programme, which issued a $2.88bn deal into strong demand. This was the largest ever deal for the PUMA programme and reflects ongoing demand for domestic credit assets which offer a reasonable yield advantage.

Market outlook

The atmospherics are in place for a near-term cut in the cash rate. The OECD recently downgraded their global and Australian growth forecasts, with the trade war taking its toll on manufacturing and business investment. While the OECD and central banks advocate for further fiscal easing to support aggregate demand, there remains some political inertia on this front which is placing a disproportionate burden on monetary policy.

While the RBA has no obvious smoking gun to trigger a near-term move, recent data readings are consistent with an economy that is growing at a sub-trend rate, exhibiting signs of spare capacity and yet to show discernible signs of responding to easier monetary, fiscal and macro prudential settings.

While the RBA Governor has noted that he see signs of a shallow recovery, we expect the cash rate to fall to 0.5% by the end of this year or early next year. The likely RBA narrative will be that further cuts in the cash rate will, in aggregate, be supportive of aggregate demand via the cash-flow and exchange rate channel. That said, the RBA run the risk that consumers may see rate cuts as signalling a worsening in the economic outlook, leading them to increase precautionary savings and dilute the potency of recent policy moves.

Thereafter, we look for an extended period of no change consistent with comments from the RBA Governor that monetary policy will not be tightened until the RBA was confident that the inflation rate was headed for the mid-point of the target band, not dissimilar signalling to the ECB. Given such an outlook, we see three year Australian government bond yields at around 73bps at the time of writing as being fairly valued. Further out along the yield curve, we see a 10 year government bond of 1.01% at the time of writing as being towards the expensive end of our fair value band.

We continue to remain attracted to maintaining a core exposure to inflation-protected securities in an environment where policy is being more firmly directed to boosting growth and lifting inflation back towards central bank targets. Despite a modest lift in breakeven inflation rates from the record low levels experienced in late August, current pricing suggests markets have little confidence that recent policy moves will bear fruit. However with the cost of buying inflation protection now so low, we feel it makes a lot of sense to position for the prospect of a cyclical lift in inflation over the next few years, especially so if one contemplates even more extreme policy measure to reflate economies.

Views as at 30 September 2019.