Commonwealth Government Bonds (CGS) are medium to long term debt issued by the Treasury through…
Following two cuts to the cash rate in May and August, the 10-Year government bond yield progressively decreased for the most part of 2016 as interest rates around the globe reached record lows. However, in the past few weeks, the 10-Year bond has risen in yield significantly from a low of 1.819% at the start of August to reach 2.303% on the 12th of October 2016. This has been a volatile transition and is being driven by multiple factors:
Figure 1. 10-Year Government Bond Yield
1. The Federal Reserve
Following the gradual removal of temporary unconventional monetary policy, the Federal Reserve’s first rate hike since the Global Financial Crisis (GFC) occurred in December 2015. While the Fed has signalled a second increase in recent months, there still remains a high level uncertainty regarding timing which continues to drive global interest rate volatility.
With the expectation that monetary easing in the US will continue to unwind in the coming years, the 10-Year US government bond yield has risen since July 2016. Historically this yield has been a leading indicator in regards to global growth and inflation and influences interest rate expectations for other developed countries. As a result, the 10-Year US government bond yield and Australian 10-Year government bond yield are highly correlated as Figure 2 shows.
Figure 2. 10-Year Australian Government Bond Yield v 10-Year US Government Bond Yield
2. Oil Price
The Organization of the Petroleum Exporting Countries (OPEC) surprised markets recently by announcing a more disciplined approach to production to counter falling oil prices. As a result, oil has rallied over the last month and this in turn is driving future inflation expectations. To control inflation, central banks typically increase interest rates and this is another contributing factor to the increasing 10-Year yield. This effect on the 10-Year yield has been stronger in the US (oil is greater contributor to the US economy) but it has spilled over into Australia due to 10-Year yield correlation explained by the first point.
Figure 3. Oil Price Vs Inflation Expectations
3. Quantitative Easing
Following the GFC, central banks embarked on extensive bond buying programs as part of unconventional monetary policy known as Quantitative Easing (QE). Since then this unprecedented level of demand has driven down yields and distorted global bond markets. The US ceased QE in 2013 but poor economic conditions in Europe and Japan has forced their respective central banks (the Bank of Japan (BoJ) and European Central Bank (ECB)) to continue.
While the BoJ has reaffirmed its bond buying program (albeit are targeting higher long-term yields) through proposed new unconventional monetary policies, there is speculation that the ECB may taper theirs in 2017. This has spooked demand expectations for global bond markets and resulted in a sell-off in most developed nation sovereign bonds including Australia.
Figure 4. ECB Quantitative Easing Bond Buying Program Growth (MoM)
4. Australia’s first 30-Year Government Bond
This week the Federal government issued its inaugural 30-Year government bond issuing $7.6 billion. The bond was priced at a yield of 3.27% p.a. which is approximately 1.00% higher than the 10-Year yield. As a result, the Australian bond curve steepened, adding to the upward pressure on the 10-year government bond yield.
Figure 5. Australian Government Bond Yield Curve before and after 30-Year Bond Pricing
The key to understanding movements in the 10-Year government bond yield revolves around where the shape of the yield curve when taking into account a “neutral interest rate”. This neutral interest rate refers to the interest rate that allows the economy to consistently grow at trend without stoking inflationary pressures. Importantly, this is not the official RBA cash rate but a long term interest rate (the 10-Year Government Bond Yield). We estimate this level to be around 3.00% whereas prior to the financial crisis it was 5.0-5.5%.
Figure 6. 10-Year Government Bond Yield v Neutral Rate
Source: Bloomberg, BondAdviser
Figure 6 shows that the current long term bond rate vs our estimated neutral rate. This clearly demonstrates the need for further economic stimulus. For this reason, we assume the official cash rate will reduce further and/or a fiscal stimulus packaged is rolled out but external market influences are artificially inflating the 10-Year Government Bond Yield and hence it is difficult to pinpoint exactly where this will land.