Monday 23 July 2018 by Stephen Koukoulas Opinion

Market sentiment sends government bond yields lower - will the trend continue?

Recent months have seen Australian money markets register a material change in market sentiment and pricing. Government 10 year bond yields, which had risen sharply in the early part of the year, have edged lower in recent months as a mix of economic fundamentals and changes in monetary policy expectations have driven market sentiment. How does this impact the corporate bond market?


Global markets - an about face

Despite hawkish rhetoric and action from several major central banks, longer dated government bond yields have fallen. Market consensus is changing, raising questions about the path for monetary policy and the global economy over the remainder of 2018 into 2019 and the evolving view suggests increasing downside risks.

Those downside risks to growth and have resulted in scaled back expectations for the number and magnitude of interest rate hikes from the US Federal Reserve, the Bank of England, the European Central Bank and the Bank of Canada, among others.

Tapering economic growth rates has seen forecasts for inflation revised lower, and this has fed into the bond rally.

In addition to these global factors, the run of news on the local economy suggests only moderate economic growth in the middle of 2018, a point confirmed with the tick lower in global GDP growth in 1Q and probably into 2Q.

There is a growing risk that global economic growth will be materially weaker in the second half of 2018 than in the first half.

The local drivers

The Australian bond market has shared in this rally. News of ongoing low wages, inflation and risks for the economy into 2019 from a fall in house prices are increasingly front and centre.

There has been a significant repricing for policy settings from the Reserve Bank of Australia. At the start of 2018, the market was pricing in two 25 basis point interest rate hikes from the RBA by end 2018 and for a further two hikes into 2020. This would have taken the cash rate to 2.5%.

Now, the market is pricing in just one 25 basis point hike by 2020 which if it eventuates, would leave the cash rate at 1.75%. There is also growing chatter from some that the next move in interest rates will be down, not up.

Indeed, this has been my forecast for some time – that the RBA will be forced to lower rates as it responds to on-going low inflation and growing risks from a loss of wealth and tighter bank credit from falling house prices.

House prices in the spotlight

Anyone who saw or has examined first hand the effects of sharp house price falls during the financial crisis in Ireland, Spain, the United Kingdom, the United States and elsewhere must be at least a little nervous with the news that Australian house prices are falling.

Since the late 2017 peaks, house prices in Sydney have fallen over 5% while the falls in Melbourne are now 3%. Perth prices have dropped around 12% since early 2015.

These falls are, at this stage, of little concern given the context of the remarkable price increases over the past decade or so. Indeed, the RBA has been aiming for a softer tone to the housing market which is why it did not follow many other major central banks and cut official rates to near zero.

That said, for the economy, the house prices falls will act as a dampener on growth. Again, this is not in itself all that concerning given the reasonable pick up in activity in areas outside the housing cycle, including non mining investment, public sector spending and to some extent, export volumes.

The issue, and the one feeding onto the interest rate expectations and bond market moves, is that these house price falls have continued in July. The risk is that they will extend to something more concerning.

If house prices were to fall 15% or more, the experience from overseas suggests problems for household wealth, confidence and spending and a further tightening in credit from the banks, which will exacerbate any downturn.

While no one is seriously forecasting a recession in Australia, the odds of one shorten with every fall in house prices.

More to it than house prices

The fall in bond yields has also been influenced by a run of mixed local economic news on retail spending, new construction and a realisation that the pipeline of public sector infrastructure spending will taper off into 2019 as several large scale projects are completed.

If the data shows further evidence of well contained inflation and wages growth over the next few quarters, the bond market rally will have further to run. Many bond investors are pricing for this, which accounts for the recent dip in yields. If the market starts to price in even the risk of the next moving in Australian interest rates to be down, not up, the fall in yields could be pronounced.

What next for bonds?

Yields are likely to remain contained and could fall further if the hard data on global growth continues to tilt to the down side. The US 10 year government bond is, for example, set to remain below 3.0% as the low inflation / mature growth dynamics prevail. A break towards 2.5% would be likely if there is more moderation in US wages growth and inflation.

According to surveys of fund managers in the US, there has also been some tactical asset allocation away from stocks, taking profit from what has been a particularly strong period over recent years. Any back up in yields in recent months has seen solid buying to counteract any upside pressure.

In terms of central bank policy settings, there is a growing consensus that the number of interest rate hikes from the US Fed, BOE, BOC and the ECB over the next six to 12 months will be scaled back to just a few if any, and that when they are delivered, they will be spaced out over an extended period. 

The corporate bond market tends to under perform in times of economic weakness as the market prices in greater risk. But it must be emphasised that major bear markets for corporate bonds occur when economies are at acute risk of falling into recession. As noted, this is not the outlook for the global economy and Australia which is more likely to see softer growth but on going low inflation.

Only if a recession became likely would the corporate bond market stage a severe and sustained sell off.

Keep watching wages and inflation

Historical episodes of sustained increases in government bond yields and interest rates more generally, are associated with accelerating or sustained high wages growth and inflation pressures. The gentle pick up in inflation and wages during 2017 which sparked a rise in bond yields appears to have been short lived. If there is a further cooling in these indicators over the next six to 12 months, bond yields will not only be well contained, but will be on track to fall further.

Central banks, including the RBA, will step back from the current rate hike scenarios that are at the forefront of their current planning if wages remain weak and inflation ticks back lower.

Bond markets are increasingly being priced for such a trend.