Australian government bond yields rallied in the latter half of the month as a correction in US equity markets and concerns about the direction of Italian fiscal policy spilled over into a broader sell-off. During this risk-off period, Australian equities fell sharply, while domestic credit markets fared better with spreads little changed. Overall, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 0.48% over October, with price appreciation from lower yields adding to the income return.
At the shorter end of the yield curve, the yield on a three year Australian government bond rose to a high of 2.06%, before ending the month 6 basis points (bps) lower at 1.99% as markets pushed back the timing of monetary tightening. Australian 10 year government bond yields moved in sympathy with US yields; the US 10 year government bond yield peaked at 3.23% towards the middle of the month and the domestic yield peaked at 2.77%. As risk appetite soured, Australia’s longer end outperformed the US, ending the month 4bps lower at 2.63%, while US 10 year government bond yields ended 8bps higher at 3.14%.
Activity-based indicators point to ongoing economic momentum, with the CBA Manufacturing PMI improving in September and building on those gains according to preliminary October data. The CBA Services PMI remains in expansion territory, but showed signs of moderating. Business conditions remained elevated in September according to the NAB Business Survey and there was a modest bounce in confidence. Consumer confidence lifted to longer run levels in October after earlier falls on higher fuel costs and out-of-cycle lifts in some mortgage rates.
Labour market data for September provided a surprise, with the unemployment rate printing at 5% rather than the 5.3% rate the market expected. The “improvement” reflected a fall in the participation rate from 65.7% to 65.4% and a 5,600 lift in total employment. While the lift in employment was modest, the quality of gains was strong, with full time jobs gaining 20,300, while part time jobs fell by 14,700. The overall composition of the result meant that the lower than expected unemployment rate had minimal impact on market pricing.
The other key release for markets was the September quarter Consumer Price Index (CPI). Expectations for a lower result, driven by a government policy-led drop in child care costs, were realised with the headline rate lifting by 0.4% over the quarter and 1.9% over a year ago. Core inflation was also subdued, with the average of the Reserve Bank of Australia’s (RBA) statistical measures up 0.3% over the quarter and 1.7% over the last year. With the RBA having signalled that it would look through this result, the release had little market impact.
Despite the volatility in equity markets and mixed domestic data, there was only a modest watering down of tightening expectations. Markets still see little to no chance for a cash rate move out to mid-2019 and have cut the chance of a tightening by the end of 2019 from around 60% to 40%. In money markets, three and six month bank bill yields ended the month 3bps and 7bps lower at 1.91% and 2.07% respectively.
Against the backdrop of equity market volatility there was some widening in the iTraxx Index, which ended the month at 81.5bps. In contrast, spreads on investment grade securities were broadly stable. During periods of volatility, primary market activity tends to be minimal, but earlier in the month the domestic credit markets did see inaugural deals for both Port of Melbourne and Heathrow Airport, which provided investors further opportunity to add infrastructure companies to portfolios.
The RBA are likely to look through both the lower inflation outcome and fall in the unemployment rate to their December 2020 forecast level made in the August Monetary Policy Statement. On the inflation outcome, childcare detracted 0.2 percentage points off the quarterly outcome and was a result of government policy.
Furthermore, it appears as though a weaker exchange rate and the first and second round effects of higher oil prices are beginning to work their way through, with tradables inflation up 0.8% over the September quarter and 1.4% over a year ago. In contrast, the yearly tradables inflation rate in the 2017 September quarter was -0.9%.
With the economy poised to grow at above trend rates over 2018 and 2019, the RBA will have some confidence in its central case forecasts that the inflation rate will settle at 2% in 2019 and 2.25% in 2020.
While the fall in the unemployment rate to 5% may overstate the rate of improvement in the labour market, moves in the unemployment rate tend to be directional over time and forward labour market indicators point to further jobs growth. What remains uncertain and the reason why the RBA is in a patient mind-set is the transmission of labour market tightening into higher wages.
In our view, ongoing labour market improvement, along with the lagged effects of a lower currency, less fiscal drag and a large public sector infrastructure pipeline, should see the RBA in a position to begin removing policy accommodation in late 2019. However, the large stock of debt held by the household sector increases the potency of monetary policy and is the reason why we are looking for a modest and drawn out tightening cycle.
We see the neutral cash rate well below the RBA’s 3.5% estimate and as anchoring the domestic yield curve. At the time of writing, the yield on a three year government bond was around 2.0% and towards the expensive end of our fair value ranges. Further out along the curve, we see a 10 year Australian government bond yield of 2.63% (at the time of writing) as being modestly expensive, with upside pressure coming from cyclical inflation risks as labour markets tighten and output gaps close.
Published by Frank Uhlenbruch, Investment Strategist, Australian Fixed Interest Team, Janus Henderson