Tuesday 12 December 2017 by Guest Contributor Opinion

The outlook for Australian bond yields

Bond yields are projected to rise in 2018 and 2019, but by how much? Where will they settle? Warren shows historically, it takes a very long while for them to rise 200bps above low points. He then forecasts end 2018, mid 2019 and long term rates

outlook

​By Warren Hogan, ex ANZ Chief Economist

For fixed income investors with a long term horizon the current interest rate environment presents many challenges. Interest rates and bond yields appear to be near the end of a long term bull market, the likes of which we only see every 40 years or so. The big question for many commentators in recent years is whether bull market which commenced with the end of the great inflation of the 1970s is over. While this is an important question and one which I believe has not been answered yet, the more important question is - what is next? If the bond bull market is over, are we due for a sudden and severe sell off to mark the end of the bull market in other asset classes.

I think we are at the dawn of a new phase for the global bond markets, one which offers a gradual rise in yields over the years ahead. This will not be a crash by any means. Indeed, the new rising yield environment will offer investors with a long term time horizon the opportunity to enhance portfolio returns.

Is the bond bull market over? A technical perspective

While I am not a technical analyst and I have some reservations about its application for both economic analysis and investing, it does help to characterise the market environment and place market participants expectations in perspective. Importantly, technical analysis helps to identify key price levels in markets that can act as a trigger for action for by others. These trigger points can also signal a shift in expectations if they coincide with a shift in the underlying economic fundamentals.

Chart 1 shows the US 10yr Treasury yield since the mid 1970s. The bull market is defined by the downward sloping yield channel evident since the early 1980s. What jumps out straight away is that despite the US 10yr yield have passed it low point a few years ago, the overall bull market channel remains in place. This is important because there have been many times in the past 30 years when the yield has made a new low point and then risen, only to ‘re-rally’ in subsequent years to new lows.

Chart 1: A Technical Perspective of the Bull Market


Source: Warren Hogan, US Federal Reserve

As has been the case many times in the past 30 years, we are now approaching the top of the bull market channel. My simple calculation is that the market needs to see a sustained break above a yield of 2.75% in 2018 to signal the end of the bond bull market. So to answer the question, the bull market is not over, but it soon could be.

The outlook for bond yields - A fundamental perspective

There are three main factors that influence Australian bond yields:

  1. The RBA cash rate
  2. US bond yields and
  3. Credit spreads 

Once you have a handle on how they interact it is reasonably straight forward to construct an outlook for Australian term bond yields.

An RBA tightening cycle is likely to commence in 2018

The RBA cash rate is the primary anchor for the Australian yield curve and determines short term funding costs in Australian debt markets. The RBA effectively sets the base for all other interest rates across the economy.

My outlook for the RBA cash rate was covered in this article, Why Australian interest rates will rise, released in November. The core view is not too different from what the consensus of economists has been in recent times, that is, a small rise in the RBA cash rate in 2018, most likely commencing in May. How quickly and how far the RBA move are always important questions for bond investors, the best time to buy long duration fixed income securities is typically near the end of a central bank’s tightening cycle.

The monetary policy outlook will be heavily affected by global trends and a cautious approach from the RBA board given high household debt levels and low CPI inflation. For this reason, I think the upcoming RBA tightening cycle will be gradual and elongated. The RBA may hike by 50bps or even 75bps in 2018 but I am confident that the tightening cycle will extend into 2019.

People are worried the RBA may burst the housing bubble, driving consumer spending into a ditch. They are wrong. Two features of household finances stand out.

  1. Debt service ratios are near long term average levels even though most metrics on house prices and debt level are at historic extremes. A small increase in interest rates will be a headwind for households with mortgages but will not be the calamity some fear. Importantly, higher rates will boost the incomes of the growing legion of self funded retirees across the country.
  2. The accumulated wealth of households from the rise in house prices has not translated into a consumption splurge like we saw prior to the GFC. Since the GFC, Australian households are much more reluctant to spend the gains they have accrued from property price appreciation. The Australian household sector has, in effect, built a wealth buffer. There will be no broad based house price panic due to a modest increase in rates.

In my view the Australian economy is moving beyond the mining boom; beyond the housing boom and beyond the construction boom to a broad based expansion in the non-mining economy lead by key industries such as health and aged care, tourism and education as well as the new digital economy.

My expectation is that the RBA cash rate will rise by 0.5% to 1% to between 2% and 2.5% by the end of 2018 and then to between 2.5% and 3.25% in 2019. This is likely to be the peak of the cycle as the tighter monetary conditions take hold.

Bond yields are also heading higher

US bond yields are expected to rise as the US economic expansion continues, excess capacity in the economy is soaked up and the Fed normalises monetary policy. This will involve both a higher Fed funds rate and QE removal, see this article, Global bond yields heading higher in 2018 – Just ask the Fed. US 10yr treasury expected to rise above 3% over the next 12 months. 

We can now pull together a basic view of the outlook for Australian government bond yields based on this outlook for US and Australian monetary policy, and the US 10yr Treasury yield. The forecast is for the RBA to broadly match the Fed on rate hikes over the next two years. The RBA cash rate and the fed funds rate are both expected to head towards 3%. The difference between short term interest rates in Australia and the US is a good guide to where the 10yr bond yield spread should be. Without complicating the analysis with extravagant and overly complex models, history says that when US and Australian short term interest rates are broadly the same then the 10yr ‘spread’ will be around 25-50bps.

The forecast for the Australian Government 10 year yield is based on:

  • The RBA cash rate rises to 3% over the next 12-18mths,
  • The US 10yr heading to 3.5% over the same time horizon,
  • The 10yr spread is expected to be around 25-50bps

These assumptions will result in the benchmark Australian Government 10yr bond yield rising to around 3.75% to 4% at the top of the forthcoming interest rate cycle.

At the ‘peak’ in the interest rate cycle the difference between the 3yr bond yield and the 10yr bond yield (‘the yield curve’) will be close to zero if not negative (an inverse curve). This implies that the 3yr yield will also get up to around 3.5% to 4% at the peak of the interest rate cycle.

These projections are summarised in Table 1.

Table 1: Interest Rate Forecasts


End 2017 End 2018  Mid 2019 Long term 
RBA Cash Rate 1.50% 2.25% 3% 2.25%
3 Year Government  2.00% 3.00% 3.75% 2.50%
10 Year Government 2.50% 3.25% 3.75% 3.00%
         
Fed Funds Rate 1.25-50% 2.50% 3.25% 2.00%
10 Year Treasury  2.50% 3.00% 3.50% 2.50%

Source: Warren Hogan

Credit spreads are likely to drift up as global monetary policy is normalised

Now this is where it gets tricky. The individual yield premium for a security over the benchmark risk free rate (that is, the local government bond rate) is made of up idiosyncratic features and broader macro features. I will concentrate on the macro drivers of credit spreads leaving FIIG analysts to help you decipher the individual credit risk of each issuer.

The macro driver of credit spreads is effectively the riskiness of the underlying equity. From a broad market perspective this can be shown with a comparison of equity market volatility and corporate bond spreads. Chart 2 shows the US AA corporate bond spread (courtesy of BoAML) and the VIX index from the CBOE. Credit spreads tend to track developments in the equity market. Any signs of stress in the equity market will be quickly translated into wider corporate bond spreads.

Chart 2: US Corporate Bond Spreads and the VIX Index


Source: Warren Hogan, St Louis Fed, CBOE

Projecting the path for credit spreads is difficult and requires a view on the riskiness of equity markets. The strongest assertion I can make is that in the absence of a major equity market disruption, credit spreads are unlikely to ‘spike’ wider. And the economic and interest rate view presented does not suggest a major equity disruption is on the horizon. Interest rates and bond yields are rising because of monetary policy normalisation. That normalisation is contingent on continuing economic growth and financial stability. This doesn’t mean credit spreads can’t widen, they probably will, but it will be orderly and modest.

Investors will be presented with many opportunities to buy into a higher interest rate environment over the next 12 to 18 months.

Long term investment strategy - A historical perspective

If the bull market is over, why buy bonds?

In other words, is a crash just around the corner? Moving away from technical analysis to a long term historical perspective provides some interesting insights. Again, I focus on the US 10yr Treasury yield. Chart CC shows the yield going back to 1870, that is, just after the end of the American Civil War. What immediately jumps out is the appearance of three long wave cycles; 1870-1920, 1920-1980 and the current cycle that commenced in the early 1980s.

Chart 3: Long Wave Cycles in Bond Yields


Source: Warren Hogan

As is indicated on the chart, the shift from the ‘bull’ phase to the ‘bear’ phase in the bond yield cycle is gradual and drawn out. For each of the first two cycles shown in the chart it took between 15 and 20 years for the 10yr Treasury yield to rise 200bps above the low point (*these data are annual average and do not capture the exact low or high points for bond yields). Neither of these cycles witnessed a bond market crash that immediately followed the top of the bull market (that is the low point for yields).

This is critically important for long term investors. The implication is that while caution is warranted once the market enters the ‘bear’ phase, we should not miss the opportunity to take advantage of rising yields, even if this means investing in shorter duration bonds through the initial stages.

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