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

Market review

Financial markets were roiled by the rapid evolution of the COVID-19 outbreak into a global pandemic. Risk appetite collapsed and liquidity conditions became challenged before powerful and unprecedented monetary and fiscal measures stabilised markets. Government bonds and credit spreads were very volatile. At one stage, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+Yr Index, was down 3.06% before a stabilisation in market conditions saw bond market returns end March 0.21% lower.

The policy response to the COVID-19 pandemic and liquidity pressures has been nothing short of astounding. March began with one cut in the cash rate and a 1% of GDP fiscal stimulus package. By month’s end we were up to our third fiscal package and when combined with the RBA’s term lending facility the total package was worth around 16.4% of GDP.”

Following an early month cut in the Reserve Bank of Australia (RBA) cash rate to 0.50%, the rapid spread of the virus and deterioration in liquidity conditions led to a counter-intuitive lift in less risky three and 10 year government bond yields. Australian three and 10 year government bond yields lifted to intraday highs of 0.60% and 2.497% on 19 March when the RBA announced an ‘out of cycle’ monetary package to complement rapidly evolving fiscal initiatives.

Measures in the RBA package included a cut in the cash rate to 0.25%, yield curve control via a 0.25% target yield for three year government bonds and a fixed 0.25% three year term funding facility for authorised deposit taking institutions worth at least $90bn. The RBA also stepped up repo operations and lifted the rate on exchange settlement balances held at the RBA from zero to 10 basis points (bps).

These measures helped restore liquidity conditions and three year government bond yields quickly settled towards the RBA target level, ending the month 26bps lower at 0.24%. As part of its yield curve control measures, the RBA also indicated that it would use its balance sheet to primarily purchase government debt across a range of tenors from the secondary market to help lower economy-wide borrowing costs. After peaking at an intra-day high of 2.497% on the day these measures were announced, the ten year government bond yield rallied sharply to end the month 6bps lower at 0.76%.

Economic readings garnered little attention as readings were pre-pandemic and markets were focused on rapidly evolving fiscal and monetary developments. For the record, the Australian economy ended up growing a steady 2.2% over 2019 with GDP up 0.5% over the December quarter. February labour market data was also fairly solid, with employment lifting by 26,700 and the unemployment rate edging down from 5.3% to 5.1%.

In money markets, three and six month bank bills ended the month 44bps and 27bps lower at 0.37% and 0.54%, with the latter buffeted by mid-month liquidity pressures. Cash expectations re-aligned, with RBA forward guidance for no change in the cash rate for around three years.

Domestic credit markets were extremely weak over the month as investors grappled with the lack of liquidity as well as ascertaining the negative impacts on corporate profitability and balance sheet resilience from the COVID-19 pandemic. The iTraxx Index ended the month at 171bps, which is an increase of over 100bps from the end of February (not taking into account the roll of an old contract series). Primary markets were closed over the month and many companies withdrew their second half and full year guidance due to the uncertainty that lies ahead.

Market outlook

The policy response to the COVID-19 pandemic and liquidity pressures has been nothing short of astounding. March began with one cut in the cash rate and a 1% of GDP fiscal stimulus package. By month’s end we were up to our third fiscal package and when combined with the RBA’s term lending facility the total package was worth around 16.4% of GDP. Unconventional monetary policy moved from the academic to practical, with the RBA choosing a combination of forward guidance and yield curve control measures via price objectives backed by unfettered access to the RBA’s balance sheet to support those price targets.

We look for a ‘U’ shaped profile for growth over the period ahead. Restrictions on population mobility are likely to push the economy into a sharp and deep recession, with significant output and job losses. Powerful policy responses will have a positive effect as they seek to limit how deep the ‘U’ will be, as well as build a bridge to the other side. Time spent at the bottom of the ‘U’ or the trough phase will be determined by the time it takes for population mobility restrictions to be lifted.

Once lifted, the rebound phase (or coming out of ‘controlled hibernation’ phase) will commence. While we expect activity to recover, economic configurations and behaviours will not be the same coming out of this pandemic as those that prevailed pre-pandemic.

Market volatility has created opportunities. We were perplexed by the sell-off in government bond yields in the face of a strong risk-off period, RBA forward guidance and yield curve control measures. We therefore sought to add duration via longer-dated securities to a number of our Australian fixed interest portfolios. Our expectation is that the yield curve will flatten given the cash rate will be anchored at 0.25% for at least three years and the RBA has a 0.25% target for the three year government bond.

We remain mindful of the tension between secular forces keeping the rate structure low with the desire to save relative to invest in ascendency. Once volatility quells, such a regime will see investors search for yield again and drive elevated credit spreads in.

Against this, massive fiscal easing and the blurring between monetary and fiscal policy raises term risk. Growth in the supply of government debt will be immense and create upward pressure on yields, other things being equal. Central banks will be under pressure to use their balance sheets to keep term structures low to create and maintain fiscal space by keeping interest costs low. Stimulus that politicians find difficult to unwind raises medium-term inflation risks, so we remain attracted to maintaining a core exposure to inflation-protected securities.

Views as at 31 March 2020.