No major change to interest rate expectations last week but interest rate markets across the…
Following the surprise election of Donald Trump as the next President of the United States, bond markets around the world have been sent into chaos. With many of Trump’s policies reflecting a pro-growth agenda, inflation expectations (a primary driver of long term interest rates) has surged taking both the Australian and US 10-Year government bond yield along for the ride.
Figure 1. Inflation Expectations, 10Y US Government Bond Yield & AUS Government Bond Yield
Since the start of his campaign, Trump has been an advocate of infrastructure spending, tax cuts and lighter regulation to ‘make America great again’. As a result, US citizens are expected to have greater purchasing power which in turn drives future inflation. While this has been a major driver of interest rates in recent weeks, technical factors such as demand and supply must also be considered.
To finance the proposed fiscal stimulus, it is likely the US government will need to borrow funds which means we can expect an increased supply of US government bonds (larger US debt stockpiles). This implies an inflection point in the current cycle given the last decade has been categorised by distortive demand as a result of large-scale central bank Quantitative Easing (QE) programs. Interestingly, the whole purpose of these unconventional monetary policies was to try and drag inflation higher but many non-academic commentators have stated a fiscal response is what the world economy really needs. It seems the uprise of Trump has proven this to be correct.
Given the improved US economic outlook and inflation expectations are tracking close to the Federal Reserve’s 2% inflation target, futures markets are now suggesting a 94% probability of a US interest rate hike in December 2016.
Figure 2. Implied Probability of US Interest Rate Hike for Fed-Fund Futures in December 2016
In the week following the Trump win, the media acclaimed ‘bondcano’ wiped $USD1.6 trillion off the global bond market with an estimated $17 billion of value coming from the Australian fixed income market. Domestically, markets are expecting a low probability (5%) of a cut to the cash rate in the RBA’s December meeting, with some commentators suggesting Australia has reached the bottom of the interest rate cycle.
Should Australian Fixed Income Investors be worried? Ultimately it comes down to whether the intended fixed income instrument is fixed rate or floating rate and whether you are long or short duration. Duration refers to how sensitive a security is to the underlying benchmark interest rate curve. If an investor is ‘long duration’, it is likely their expectation is interest rates are going to fall (and prices will rise). On the other hand, if an investor is ‘short duration’, it is likely their expectation will be that interest rates are going to increase (and prices will fall). As a result, investors can adjust their portfolios to take views on movements in interest rates. Given Trump’s victory and the subsequent bond rout was unanticipated, many ‘long duration’ investors would have been caught out.
Figure 3. Duration effect of Australian Government Bonds Maturing in 2020, 2030, 2040 and 2047 post the US election (index rebased)
In Australia, the retail market is primarily categorised by floating rate, low duration securities while the institutional market has a larger exposure to fixed rate, high duration securities. Many institutional (i.e. superannuation) mandates require a proportion of funds to be invested in fixed rate, relatively longer duration government and state government securities. This includes exchange-traded funds (ETFs) that track Australian fixed income indices (i.e. AusBond index is ~70% weighted to government or state government securities). On the other hand, most ASX-listed securities have distribution rates that reset on a quarterly or semi-annual basis and as a result, are not locked in to a single interest rate level for an extended period of time. Interest payments for these securities are anchored to the short end of the Australian yield curve (which moves with the benchmark interest rate curve) which is by driven monetary policy and the cash rate decisions rather than long-term expectations for inflation and economic growth. Given the RBA is expected to leave rates on hold, short term interest rates have remained relatively stable while long term interest rates have increased significantly, resulting in a substantial steepening of the domestic yield curve.
Figure 4. 90-Day and 180-Day BBSW
Source: Bloomberg, AFMA
Overall, we expect interest rate volatility to have a limited impact on retail investors. While some exchanged-traded funds would have been negatively impacted by the sudden steepening of the Australian yield curve, the performance of individual ASX-listed securities has remained relatively stable. We note that there are some implications for credit risk of underlying issuers of these securities (particularly those with an international presence), but this is monitored by the BondAdviser credit research team. For this reason, we believe retail investors are positioned well for any forthcoming volatility in global interest rate markets.