Australian government bond yields continued to rally as markets moved to price in near-term monetary easing. The longer end of the curve benefitted from flight-to-quality flows as trade tensions flared and expanded to include US/Mexico relations. Sentiment shifted from ‘risk-on’ to ‘risk-off’, with equity markets falling heavily and credit spreads widening. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 1.7%, with price appreciation from lower yields boosting the income return.
Three and 10 year government bond yields drifted lower in the lead up to a speech by the Reserve Bank of Australia (RBA) Governor on the outlook for the economy and monetary policy. In that speech the Governor signalled that the RBA would consider the case for lower interest rates at its June meeting. Yields subsequently rallied, with the long end boosted late in the month by the US decision to apply tariffs on Mexico. Three and 10 year government bond yields ended the month 18 and 33 basis points (bps) lower at 1.10% and 1.46% respectively.
Money market yields reacted to the RBA signalling by bringing forward the timing of the first easing to June. Three and six month bank bill yields fell by 14bps and 21bps to end the month at 1.42% and 1.41%. Markets are now fully pricing in a second easing by September and assigning around a 75% chance of a 0.75% cash rate by May 2020.
On the political side, the Coalition government defied the polls and retained government. From an economic perspective, partial demand indicators point towards another quarter of sub-trend growth in the upcoming March quarter national accounts. While net exports are poised to add to growth, a 0.1% fall in Q1 real retail sales suggest that consumption remains weak.
The labour market appears solid but forward indicators point to some moderation. Jobs rose by a stronger than expected 28,400 in April, with the participation rate climbing to a cyclically high 65.8%. However, as not all new entrants were able to find employment, the unemployment rate rose from 5.0% to 5.2%. A lift in the underutilisation rate from 13.3% to 13.7% suggests that there is still spare capacity despite 322,900 people finding employment over the last year.
Forward labour market indicators point to a moderation in labour demand, with the April NAB Business Survey consistent with employment growth of around 14,000 per month, a rate which will make it difficult for the unemployment rate to fall further. Wages growth remains moderate, with the March quarter Wage Price Index gaining 0.5% for an unchanged yearly rate of 2.3%. The Fair Work Commission announced a 3% lift in the minimum wage, down from 3.5% the previous year, but well above the prevailing rate of wages growth.
Credit markets were not immune from the ‘risk-off’ sentiment experienced in other markets, with the Australian iTraxx Index widening 13bps and finishing May at a spread of 79bps. The return of the Coalition government, as well as APRA announcing some potential easing of lending restrictions, had a muted impact on major bank credit spreads, but hybrid securities benefitted from the removal of the possible changes to franking credits. Primary markets were quiet compared to the previous month, but the one highlight was NAB issuing $1bn of new subordinated bonds at a credit spread of 215bps.
Following the RBA Governor’s speech, we brought forward the timing of our two rate cuts and now look for the RBA to move at its June and August meetings. It appears as though the economy (which has slowed from above trend growth rates in the first half of 2018 to below trend rates from mid-2018 onwards) is about to get a complementary policy boost made up of:
• 50bps of monetary easing;
• a relaxation in macro prudential settings;
• tax cuts worth around 0.5% of GDP (similar impact to two rate cuts); and
• a 3% boost to the minimum wage following the latest Fair Work Commission decision.
These in aggregate provide a near term pro-cyclical pulse that should help underpin activity at a time when the housing sector is cooling. We see some merit in the RBA pausing after a June move to give it time to assess whether some of the more recent slowing had a ‘deferral component’ as economic agents waited to see the outcome of the election. It appears as though activity levels have picked up in key property markets and stabilisation in house prices would see an end to the negative wealth and confidence effects from falling house prices.
By bringing easing forward, the RBA have reduced the risk of having to ease more later. The growth outlook over the second half of 2019 should also benefit from a return to normal seasonal conditions and the end of the drag to growth from the completion of large LNG projects.
While we see the near-term risks tilted to the low side given current trade tensions, markets largely pricing in 75bps of easing by mid-2020 takes the shorter end of the curve to being fully-priced in our view and susceptible to any post-election pick-up in sentiment/activity and ‘less pessimistic’ RBA signalling. That said, with the end of the current easing cycle still a long way off, the scope for a material sell-off at the shorter end is limited.
Further out along the yield curve, we see the yield on a 10 year government bond of 1.49% (at the time of writing) as being modestly expensive, pricing in low terminal rates by historical standards and offering investors little reward for taking on term risk.
Published by Frank Uhlenburch, Janus Henderson