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 lower on global growth concerns. However, the prospect of an interim trade deal, reduced risks of a hard Brexit and monetary easing in the United States, led to a recovery in risk appetite that saw government bond yields end the month higher. Improving sentiment supported equity and credit markets. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell by 0.49%, with price depreciation from modestly higher yields offsetting the income return.

Three and 10 year government bond yields fell to their mid-month lows of 0.59% and 0.88% following weaker European and US manufacturing data. Yields began to lift as news of an interim trade deal and Brexit deal filtered through. The Reserve Bank of Australia (RBA) Governor’s comments that the economy was at a gentle turning point and that negative interest rates were extraordinarily unlikely in Australia led markets to wind back the amount of easing that had been priced in. Australian three and 10 year government bond yields ended the month 7 basis points (bps) and 12bps higher at 0.81% and 1.14%.

Australian data releases were consistent with growth running at a sub-trend rate and limited signs to date of recent fiscal and monetary easing boosting domestic demand rather than asset prices. While there was an encouraging 0.4% lift in August retail sales, consumer sentiment fell sharply in both August and September with indications that uncertain consumers are saving rather than spending recent gains.

Despite a small improvement in business conditions in the September NAB Business Survey, both confidence and activity measures remain below longer-run measures and have yet to show signs of responding to earlier policy stimulus.

There was also a modest improvement in labour market conditions in September, with the unemployment rate easing back from 5.3% to 5.2%. Employment growth of 14.7k was in line with expectations however a 26.1k lift in fulltime jobs helped improve the tone of the release. Forward labour market indicators point to jobs growth being sufficient to hold the unemployment rate at around current levels but not strong enough to absorb remaining labour market slack.

Overall price pressures in the economy remain subdued and indicative of some spare capacity. The average of the RBA’s statiscal measures rose by 0.4% for a yearly rate of 1.4%, well below the bottom of the RBA’s 2% to 3% target range. That said, there were signs of earlier currency weakness being passed through with tradeables inflation lifting by 0.9%. In contrast, non-tradeables inflation rose by only 0.4% over the September quarter.

Even though RBA communications indicated that they would ease again if required, markets pushed back the timing of the next easing and wound back expectations for the amount of easing. Market pricing for a December easing that would take the cash rate down to 0.5%, shifted from around a 50% chance, to a 20% chance by the end of the month. Markets also moved from fully pricing in a 0.5% cash rate by May 2020 to around a 70% chance. Both three and six month bank bill yields ended the month 2bps lower at 0.93% and 1.03%.

Credit markets benefitted from the improvement in risk sentiment.  Derivative markets outperformed, with the Australian iTraxx Index rallying 8bps and there was some modest spread tightening in physical markets. Primary markets were active and well supported with issuance in both the corporate and asset-backed sectors. Issues of note came from Coles and Origin which were both well oversubscribed.

Market outlook

The move by the US Federal Reserve (Fed) to ease monetary policy at the end of the October and signal that it remains on hold unless there is a material change to the outlook, suggests that the “insurance phase” of recent offshore policy moves may be coming to a close. While central bankers have provided policy accommodation to offset the drag to world growth from the trade and technology dispute, they, along with the OECD and IMF, note the monetary policy has its limits and there is scope for fiscal policy to play a greater role in supporting aggregate demand.

Although both the Fed and the RBA have cut the cash rate by 75bps since July, it is still too early to completely rule out a further move by the RBA. Recent data readings suggest that the real economy has yet to show material signs of responding to easier monetary and fiscal conditions, though asset prices, particularly Melbourne and Sydney house prices have begun to respond.

While monetary policy operates with a long and variable lag, we think there is a high probability of further easing that would take the cash rate to 0.5% late 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 economic outlook, leading them to increase precautionary savings despite the recovery in house prices.

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 and Fed. Given such an outlook, we see three year Australian government bond yields at around 79bps at the time of writing as being fairly valued. Further out along the yield curve, we see a 10 year government bond of 1.10% at the time of writing as approaching fair value levels.

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

Views as at 31 October 2019.