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On the 16th May 2016 the Australian Government 10-Year Bond Yield dropped to a record low of 2.22% as the interest rate futures market reacts to a period of possible disinflation. This has been a driving force behind the bond markets outperformance year to date (AUSBond Composite 3.65% YTD, vs ASX200 Accumulation 2.40%). While this is good for those who are long duration (security price sensitivity to changes in interest rate expectations) its makes it very difficult to predict the future path of interest rates (i.e. market is effectively pricing in little to no inflation and sub-trend growth for the next 10 years) and for those investors looking for a replacement for term deposits rolling off (at ~4-5%) there is little option but to take more risk to maintain a consistent income stream.

The whole market (i.e. Economists, traders and analysts) has little doubt that the Reserve Bank will cut interest rates again (at some point) and some are saying the possibility of disinflation could warrant the first back-to-back easing in four years. Note that if the RBA do cut rates in June this would signal a level of urgency that the board last showed during the European Debt Crisis in 2012. At this stage the market is pricing in a ~25% chance of a June rate cut to 1.50% but we expect that the RBA is closely looking at the inflation expectations internationally which have dropped pretty quickly. For the sake of education, disinflation and deflation are different. Disinflation shows the rate of change of inflation over time (the inflation rate is declining over time but remains positive) whereas deflation is a decrease in general price levels of throughout an economy. The issue for policy makers if whether or not inflation targeting of 2.0 – 3.0% is worth pursuing in the short term (it is a core mandate) given its expectations are 1.5 – 2.5% out to June 2018 and the market think these are ambitious. The next read on the strength of inflation will come with wage price index data on Wednesday and will be a key determinant of disinflation in the second half of 2016.

 

The rally in credit (tighter trading margins) seems to have stabilised temporarily as the market deliberates on the recent change in absolute yields and news flow about potential bad loans and fraudulent underwriting continues to leak across the banking sector. AMP’s quarterly update on Friday was also below expectations as higher income protection claims impacted the Wealth Protection unit while the AMP Capital business unit experienced a drop in assets under management. The market is looking for a new positive to drive asset prices higher (other than more monetary easing) but is struggling for a catalyst. The yield curve is flat and with the uncertainty around what the Federal Reserve will do with interest rates, many traditional fixed income strategies (i.e. yield curve roll) will no longer work. Value strategies (that is buying higher yielding securities with improving fundamentals) is becoming increasingly important to achieve income goals.

 

Click below for Interactive Charts

Chart 1: Bloomberg AUSBond Composite Index (Monthly)

Chart 2: Bonds vs Equities 2015/2016 (Monthly)


 

Interest Rates

 

There is a fundamental disconnect between the Federal Reserve and the interest rate market which was amplified last week when US Treasuries continued to rally (i.e. Yields were lower) even following reasonably strong economic data. One of the catalysts for this move was Janet Yellen said that she would not completely rule out the use of negative interest rates in some future adverse scenario. While this is not completely new news and not even being tabled at this stage the market now has written evidence of the tail risk downside which arguably was not there before (this is still a murky area). The rally in the US yield curve is to some extent due to it being attractive in a relative global sense (i.e. negative rates in Europe and Japan) as the probability or rate hikes has reduced.

 

The domestic yield curve is flat and overall yields across the curve are low. In February 2015, the 10-year bond yield hit an all-time low of 2.27% before lifting to highs near 3.15% on the 11th of June 2015. In early November 2015 there was a progressive increase in yield from ~2.60% to a high of 2.99%. But since December the flight to quality meant the 10-year yield gave back the changes in Q4 2015 and on the 16th May 2016 the Australian Government 10-Year Bond Yield dropped to a record low of 2.22%. The 3-year bond has followed a similar pattern and broke out of its recent yield range (1.90 – 2.10%) in November / December 2015 reaching a high of 2.18% on 7 December 2015. It has since collapsed to reach a low of 1.54%. On the 13th May 2016 the ASX 30 Day Interbank Cash Rate Futures June 2016 contract was trading at 98.295 indicating a 23% expectation of an interest rate decrease to 1.50% at the next RBA Board meeting (down from 34% last week).