The decision to hold the cash rate steady at 2.0%p.a. yesterday allows another month, at least, to see if:
(1) the brakes recently put on investor lending ease their housing market concerns
(2) mixed economic data starts to take a direction one way or another
Currency market overreaction
Bond market yields moved very little on this news, but the AUD jumped over 1c off the back of the removal of their previous comments that the AUD is too high.
The RBA’s removal of these comments simply means that they don’t feel the need to publicly state they believe the dollar is too high. It doesn’t necessarily mean that they now think it is fair value. The market’s immediate reaction seems like overkill, particularly in light of the small bond market reaction. For those interested in currency markets, these over-reactions are an opportunity to take long positions in USD or GBP denominated assets such as corporate bonds.
Long-term bonds offering strong yields, for now
The real driver of long-term currency values is long-term interest rates, which are in turn driven primarily by market expectations of the RBA’s rate decisions in the future. These future decisions will be driven by Australia’s economic growth prospects. At the current yields of 2.03% for the 5 year government bonds and 2.71% p.a. for 10 year government bonds, the market is assuming that the RBA cash rate will remain around 1.5% to 2.5% p.a. for the next five years, but then average 3.5% p.a. thereafter. In normal economic conditions, this would be a fair long-term assessment as it would be reasonable to assume that the economy will return to its long-term averages. But these are not normal economic conditions.
The long-term prospects for the Australian economy are currently very difficult to forecast. So much of our economy is now linked to China’s economic future, which itself is increasingly uncertain and opaque. Exports to China now drive 6% of Australia’s GDP, a well-publicised fact. But Chinese investors are also heavily funding the current construction boom on the east coast, particularly in the apartment and commercial markets.
Furthermore, the long-term prospects for Australia, i.e. the replacement of the mining investment boom, are as yet unknown leaving Australia heavily reliant upon net migration, which is again increasingly tied to China. In short, if China has an economic hard landing, the construction cycle will fall sharply, commodity prices will fall sharply, and unit prices in the eastern states will fall sharply.
In the absence of a China slowdown, Australia’s future is still far from certain. So far, construction in the eastern states has been the main replacement for the mining investment boom. Construction has been the second largest contributor to economic growth over the past decade, closely followed by Financial Services (an industry closely linked to construction). But the construction cycle will end as the undersupply in those markets turns to oversupply. This is expected by industry experts such as BIS Shrapnel to occur in Brisbane and Melbourne within the next 12 months, and in Sydney by 2017/18. Sydney still faces a significant undersupply, but dwelling approvals have been an unsustainable 50% above long-term average levels for more than 12 months. The current constraints on investor lending could see that cycle end much earlier.
If China’s prospects turn more positive, Australia’s GDP will certainly benefit through construction, broader investment inflows, net migration and tourism, and the resulting inflation will probably force the RBA to increase rates. But the base case scenario at the moment is one clouded by declining Chinese prospects and a lack of momentum for the rest of the Australian economy.
In that scenario, long-term bond yields represent good value. Markets have been slowly realising that the long-term GDP growth rate for Australia has structurally shifted downwards. Our preferred strategy for this base case is to build a well diversified portfolio of long-dated bonds, hedged using inflation linked bonds for the less likely scenario that inflation forces rates higher.
For more information, please speak to your FIIG Representative.